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Importance of Determining an Asset Allocation Strategy
Why Asset Allocation
One of the most important questions which we face in our financial life is how much we need to save and invest? The amount is precious as it comes from you sacrificing on today’s luxuries for tomorrow’s comfort. Therefore the money you decide to save is too important to be invested without a strategy. It is for this reason, asset allocation becomes extremely important. Simply put, it divides your hard earned investment into various asset classes that gives you the potential to earn higher returns while lowering the risk by diversification.
Factors that play an important part in determining your Asset Allocation Strategy
There is no set formula for determining an asset allocation strategy that works for you. It is different for each individual investor. Your asset allocation strategy will largely depend on:
Risk tolerance
Your willingness to brave ups and downs of the market for more potential returns in the long-term. You may be happy with 25% returns but are you also willing to take a loss of 25% on your investments? You may be willing to take risk in a bull market, but your true risk tolerance may be tested in a bear market.
Time horizon
How long can you stay invested without withdrawing or selling your investments? Also how long do you expect or want your corpus to last?
Financial Objectives
What are your financial goals? Do you want to invest to improve your current lifestyle? Or you want to build a corpus for your children’s education, maintain the current lifestyle post retirement or buy a new house?
Liquidity needs
How much do you need each month to maintain your current standard of living? What are your present assets? Do you expect to spend a lot of money in the near future on marriage, education or a medical requirement?
These are some of the important questions that can determine which asset classes will best reflect your risk tolerance for volatility. These critical factors can help you identify a successful asset allocation strategy.
Why is it so important to determine an Asset Allocation Strategy?
Expanding Options. The array of alternate investment options are growing day by day for investors. While they certainly make the portfolio construction process more complicated, they also provide new corridors for increasing potential returns while managing risk. It becomes important to, therefore, understand all options and then take an informed decision on which asset classes you want to choose and how much you want to allocate to each of them.
Risk Management. Your asset allocation strategy must make optimum use of diversification. This not only enables you to manage volatility by reducing risk and increasing potential returns, but also helps you ride the ups and downs of the market with more confidence.
Asset allocation strategies can be
Conservative
with more exposure to debt
Moderate
balance between debt and equity
Aggressive
more exposure to equity
Determining the right asset allocation strategy will help you to successfully meet your long-term or short-term financial goals. For example, for long-term goals, an aggressive asset allocation strategy with more exposure to equity mutual funds may be preferred as it helps generate higher potential returns, while reducing risk and beating inflation. It may be better to invest in safer options or follow a conservative asset allocation strategy for short-term goals. Determining the right strategy will help you strike this balance.
There are a lot of online websites offering asset management tools to determine the right asset allocation mix. Some are in the form of simple online calculators, while some ask for additional information to suggest an asset allocation strategy. While it may help you finalise your asset allocation, you should also be aware of the limitations of online asset allocation tools before closing on a decision.
Firstly, as each online tool uses different assumptions on interest rates and potential returns, each one is likely to give you a different suggestion on asset mix from the other. Secondly, most asset allocation websites and calculators don’t take taxation into account. In actual investing, tax plays a huge role in your choice of investment.
However, inspite of these limitations, they are quite useful and give an idea if not a specific answer. Using the right asset allocation strategy will place your investment portfolio in a better position to deal with market dynamics. Coupled with financial discipline, it will ensure that you get closer each day towards achieving your financial goal.
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TIPS
#1
Diversify your investments under each asset class.
#2
Make sure you evaluate your asset allocation strategy periodically, especially after any major life event like marriage, having children or retirement.
#3
Equities have so far been the best option to achieve long-term financial goals, beating inflation.
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