A diversified portfolio is the KEY to right Financial Planning! Read more

Most of us are familiar with asset allocation even if we don’t recognize the term. 

For example, have you ever noticed that street vendors often sell seemingly unrelated products – such as umbrellas and sunglasses? Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never – and that’s the point. 

Street vendors know that when it’s raining, it’s easier to sell umbrellas but harder to sell sunglasses. And when it’s sunny, the reverse is true. By selling both items- in other words, by diversifying the product line – the vendor can reduce the risk of losing sales on any given day. 

In this article, we will look at what asset allocation is, why it’s probably the most important investment decision that you’ll make.

What is asset allocation?

Asset allocation is the process of determining the right mix of investments you should own; your exposure to various asset classes – equity, debt, cash, property, commodities, precious metals. How you invest within them is diversification.

So by allocating assets, you are essentially adopting an investment strategy that can balance your portfolio’s risk and reward keeping in mind your risk profile, your financial goals, and your investment time horizon.

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What is the most ideal asset allocation?

There is no such thing as an ideal allocation. Your asset allocation will keep changing over time depending on the following factors:

• Your financial goals and investment horizon

We all have goals. Whether you aspire to build a fat retirement fund, own a holiday home, pay for your child’s education, or simply save for a new car, you should consider it in your asset-allocation plan. All these goals need to be considered when determining the right mix.

For example, if you plan to build a fat retirement fund, you don’t have to worry about short-term fluctuations in the stock market. But if you have a child who will be entering college in five to six years, you may need to tilt your asset allocation to safer fixed-income investments. 

• Your risk tolerance 

The second major factor influencing asset allocation is your risk tolerance. You may be willing to take on higher risks to get better returns if you are an aggressive investor or have a high risk tolerance, or you may stick with low-risk investments aimed more at capital preservation if you are a conservative investor with low risk tolerance.

Why is asset allocation important?

Asset allocation helps you reduce risk through diversification. Historically, the returns of equity, debt, and other asset classes haven’t moved in unison. Market conditions that lead to one asset class outperforming during a given timeframe might cause another to underperform. The result is less volatility for you on a portfolio level since these movements offset each other.

In addition, asset allocation is important because it has a major impact on whether you will meet your financial goal. If you don’t include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement or college, you will likely need to include at least some stock or stock mutual funds in your portfolio. On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stock or stock mutual funds, for instance, would be inappropriate for a short-term goal, such as saving for a family’s summer vacation.

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Bottom line

Asset allocation is one of the most important decisions that you will make for your financial future. By choosing the right mix of stocks, bonds, cash, and other asset classes, you can ensure that you’re set up to reach your financial goals.

Happy Investing!