Importance of Asset Allocation for Long Term Investment Success

Posted On Monday, Jan 08, 2024


In the world of investments, risk and reward are generally correlated. A low-risk investment option usually generates low returns and vice versa. However, if you do not take enough risk, you may not be able to counter inflation and accumulate enough corpus to meet your financial goals. On the other hand, if you take too much risk, it can expose your portfolio to very high volatility. But if you follow the right asset allocation, you can be assured of earning potential returns without attracting undue risk.

What is asset allocation?

Asset allocation is an investment strategy that balances the risk-reward trade-off by diversifying investment across different asset classes such as equity, debt, and gold.

Notably, different asset classes perform differently depending on the varying macroeconomic situation; sometimes equities outperform (like they did in 2014, 2017, and 2021), and other times, it could be debt or gold.

So, when you invest across multiple asset classes that share generally a negative correlation with one another, it reduces dependence on a single asset class. Consequently, the impact of any sharp negative movement in one asset class is usually mitigated by the likely rise in other asset classes. 

Why is Asset Allocation so important?

Prevents irrational behaviour

A disciplined approach is important for achieving goals. If asset allocation is done optimally as per your risk appetite, financial goals, and investment horizon, it may help eliminate irrational behaviour such as greed and fear, which otherwise could harm the growth prospects of your investment.

Minimises risk and maximises returns

Equities have high return potential, but they are also susceptible to high volatility. This risk can be balanced out if you invest in other asset classes. Investment in debt instruments acts as a cushion against market volatility by offering a sort of stable returns, while gold acts as a portfolio diversifier. Thus, you earn risk adjusted returns across market phases.

Helps you stay on the right track to the goal

Asset allocation allows you to align your investment with your financial goals. Equities are suitable for long-term goals, whereas debt is suitable for short-term goals and for building an emergency corpus. By including a mix of equity, debt, and other asset classes, you create a balanced portfolio to meet your various short-term and long-term needs.

How to decide what is the best-suited Asset Allocation?

To decide the best and the most suitable asset allocation that aligns with your financial needs, you need to pay attention to the following factors:

Financial Goals

The financial goal you wish to achieve is an important step that helps you determine the best-suited asset allocation. An investment without a specific goal is just like driving a car without a destination in mind. Your goals should be quantifiable and measurable. Based on your goals, you will be able to arrive at the amount to be invested, the expected rate of returns, and the most suitable assets that will help you achieve each of these goals.  

Risk Profile

Different types of investment carry different risk-reward profiles. It is important to understand the risks related to each of the investment avenues and pick the one that aligns with your risk tolerance levels. If you have a high-risk profile to handle market volatility, you can consider high-risk instruments such as equity mutual funds. Do note that your age, financial circumstances, the life stage you are in, etc., can affect your ability to take risks.

Investment Horizon

Your investment horizon is the time period for which you will hold on to your investment before selling it. A long-term investment horizon allows you to follow an aggressive investment approach as you will have enough time to recover from any short-term losses and sharp fluctuations. On the other hand, if you have a short-term investment horizon, then you should opt for relatively stable asset classes and instruments to reduce the impact of market volatility.

How to allocate when investing in Mutual Funds?

Asset allocation with mutual funds can be achieved if you tactically allocate exposure across various Equity Funds, Debt Funds, and Gold (via Gold ETFs or Gold Funds). All you need to do is select the right and most appropriate schemes within each of these categories and invest as per your preferred asset allocation plan. 

You may consider building your portfolio with Quantum Mutual Fund’s DIY 12-20-80 Asset Allocation Strategy, a time-tested approach that has the potential to minimise downside risk and achieve your long-term goals. Start by setting aside 12 months of regular monthly expenses (including EMIs on loans) for an emergency fund, and consider parking it in a pure liquid fund, such as Quantum Liquid Fund, and/or a separate savings account. The balance can be split between equities (80%) and gold (20%).

The equity portion can consist of different styles of investing like Growth & Value – Funds that can be considered  Quantum India ESG Equity Fund , Quantum Small Cap Fund and Quantum India Long Term Value Fund which shall offer you the benefit of diversification across market caps &  strategies.

For investment in gold, prefer to invest via Gold Funds or Gold ETFs such as the Quantum Gold Fund and Quantum Gold Savings Fund. The benefit of investing in Gold via mutual funds is that you do not have to worry about purity, pricing, or issues related to the storage of physical gold. This Asset Allocation Strategy could potentially offer your portfolio the correct mix of stability, growth, and protection.

Strategies for Asset Allocation

Remember that there is no one-size-fits-all strategy for asset allocation. Your individual circumstances, goals, and risk tolerance will determine the most appropriate allocation for you. Consider your investment style and beliefs. Some people prefer passive investing like index funds and ETFs, while others prefer active management. For long-term goals, you might allocate more to equities; for short-term goals, you might lean more toward debt.

To conclude:

Asset allocation is the cornerstone of successful investing. When you wisely define and follow the right asset allocation as per your age, risk profile, investment objective, financial circumstances, the financial goals you wish to address, and the time to achieve those envisioned goals, among other factors, it will serve as an effective investment strategy that will help you achieve your financial goals.

If and when your investment objective undergoes changes or if you notice a sharp deviation in the portfolio from the target allocation (of +/- 10% or more), consider rebalancing your portfolio from equity to debt, or vice versa to align it with your financial needs.

Above article is authored by Quantum.

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