The Importance of asset allocation
The first question a novice investor asks from the beginning of financial planning is “Where do I invest?” when they first begin investing.
Selecting the best asset class to invest in is the first step in building wealth. An asset class is a collection of identical investment vehicles.
Asset allocation is the process of distributing your resources among several asset types.
To put it in another way, by altering the percentage of each asset in an investment portfolio in accordance with the investor’s risk tolerance, goals, and investment time period, asset allocation is the implementation of an investing strategy that seeks to balance risk with profit.
Broadly speaking, there are 4 key asset classes: Equity, Real estate, Debt and Commodities. These are further grouped into 2 categories:
- Growth
- Defence
According to research by Brinson, Singer, and Beebower published in their paper “Determinants of Portfolio Performance II: An Update,” asset allocation, followed by security selection and market timing, accounts for around 93% of the return variation between portfolios.
There are a huge variety of assets available, and each has its own risk and return trade-offs. An investor can put together their own basket according to their risk tolerance.
Most frequently, an investor will select one of the asset classes listed below.
We have been attempted to be capture the typical risk and return possibilities of these asset classes.
Stocks have return of 10-18% and a 15% risk factor, Mutual funds have a return of 12-14% and a 13% risk factor while PMS come with a return of 14-30%
Stocks have a return of 10–18% and a risk factor of 15% over a three-year period in the equity asset class, mutual funds have a return of 12–14% and a risk factor of 13%, while PMS have a return of 14–30%.
In the debt asset class, the returns on the following investments over a three-year period range from 5-7% for mutual funds with a 1.5% risk component to 3-6% for fixed deposits and 7% for PPF with a nearly non-existent risk factor.
Investments in gold produce returns of 8–12% with a 7-9% risk component, whereas real estate generates a 3% CAGR over a five-year period and carries a modest risk.
The significance of asset allocation can be demonstrated by the following example:
The first scenario is one in which an investor only invests in equity and not in debt. The asset mix is then made up of 100 percent equity and 0 percent debt. Their portfolio has a starting value of 100. If the market changes and equity prices drop by 20%, the portfolio’s worth at the end of the year will be 80.
Let’s consider another scenario, If an investor splits their money equally between equity and debt, their asset mix is then split 50/50. Their portfolio has a starting value of 100. If the market changes and equity declines by 20%, as in scenario 1, but the debt investment generates a 5% return, the portfolio’s value at the end of the year will be 92.5.
As a result, as the two examples show, asset allocation has a significant impact on the performance of a portfolio.