Categories
Finance Investment Strategy Portfolio Management

Introduction to Asset Allocation – Part I

Guest Post – Tanumoy Hazra

Introduction

Asset Allocation is an investment process which aims at allocating capital in different assets classes (eg: stocks, bonds, cash, gold, etc) that helps in balancing the risk and returns in a portfolio in accordance to the investor’s goals, risk tolerance and investment horizon.

Examples of types of Assets

Stocks – You get this asset when you put money into a specific company. Essentially, when you buy shares, you’re getting pieces of that organisation’s earnings and assets. Businesses sell stocks to raise funds. Shareholders get money by selling the stock for a higher price when its value increases (this is called capital appreciation). Another way to earn through this investment is through dividends, which the company regularly distributes to investors.

Bonds – Bonds are basically an establishment of a loan contract between the issuer (the company) and the lender (the investors). The bond issuer then repays the borrowed amount with periodic interest payments and final repayment of the principal at maturity. These investments have fewer risks, but also lower returns relative to stocks. Bonds are also called “Fixed Income” assets because generally the amount of interest you receive periodically is “fixed” (there are other variants of bonds which will be covered in a future article)

Mutual Funds – If you aren’t too keen on having to go through the trouble of finding the right mix of assets to invest in, mutual funds enable you to buy different investments in just one transaction. Mutual Funds pool basically pool money from investors and use that amount to buy stocks and bonds through a professional manager. The more number of units of the fund you buy, the more exposure you have to the fund’s performance.

Thought Bubble: Each asset carries with it a certain level of risk and expected return. For example, within the fixed income space, a Government bond would be low to no risk, and hence low return, compared to say a bank Fixed Deposit, which is not completely secured (bank FDs are secured to the extent of Rs. 1 lakh by the Deposit Insurance and Credit Guarantee Corporation – DICGC), and hence slightly higher risk, with slightly higher return, compared to say a completely unsecured corporate bond, which is significantly higher risk and therefore has to offer commensurately higher return.


However, not all assets will reward higher risk with equally high returns, this is where the concept of “diversification” becomes pivotal. More on the same in Part II.