Heard of farmers cultivating a mix of crops in their fields? Ever wondered why they do it? What are the benefits? Well, the benefits are simple and aplenty.
When you cultivate a mix of crops in your farm, it helps improve your farm income from a variety of crops yields and protects you from the failure of a particular crop in unsuitable weather conditions. Overall, good effects result when the right combination of crops is grown together.
Asset Allocation works on the same principle. Like planting the seeds of multiple crops in a farm, you have various asset classes that you can invest in. Your portfolio performance depends on the mix of asset classes to a large extent. This mix of asset classes known as Asset Allocation, is one of the most important strategies you can devise to optimize the performance of your portfolio.
What is an asset and asset class? Why is asset allocation so important? Let’s find out.
Assets & Asset Classes
An asset is anything that has value such as cash, real estate, or even antique artifacts or art. In investing, similar assets are classified into asset classes. In India, the three key asset classes for investments are:
Other than these, there is real estate, gold, etc. These can be looked at as additional asset classes.
Within each asset class, investment instruments have similar risks and returns, and are regulated by the same body and react in the same way to market movements.
How should you divide your capital among these asset classes? What should be the percentage of each asset class? How do you determine the asset mix that is right for you? This is what asset allocation is all about.
Asset allocation is a portfolio investment technique that targets balancing risk by determining the proportion of capital spread across various asset classes: equity, debt and cash. Each asset class behaves differently over time and has different risk and return profiles. Similar to diversification, it works on the basis that at any given time, the poor performance of an asset class will be offset by the good performance of another asset class within the investment portfolio.
There is no single formula that can determine the right asset allocation for you. A one-size-fits-all approach to asset allocation does not work as it depends on your risk profile and the time horizon you are looking at for your investments.
To invest wisely, it is important to determine your asset allocation depending on your life stage and risk tolerance. It is advisable to seek an expert’s advice in doing so.
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