The importance of asset allocation lies in the overall risk-return performance of your portfolio. Both asset allocation and rebalancing your portfolio when required, play an important part in having a well diversified and a disciplined investment approach. The number of benefits provided by these 2 relatively straightforward investment strategies is immense.
Benefits of a Diversified Portfolio
I) Lower investment risk
A diversified portfolio will be exposed to lower investment risk, because the growth prospects are not limited to just one risky security, but rather a basket of both risky and non-risky securities, across equity, debt, gold and real estate.
II) Low dependence on a single asset for returns within an asset class
Not all assets within a single asset class e.g. equity, perform well at the same time. This is what makes it so important to choose different stocks and different categories of mutual funds, e.g. large cap, value style and so forth, and allocate funds efficiently even within the same category.
- Protection from Market Turbulence
Anybody who has lived and invested though the sub-prime mortgage crisis knows that when equity caused the ground to fall out from under our feet, debt and gold kept investor’s heads above water. For those who had pure equity portfolios, it was a mistake they will likely never make again. A well diversified i.e. a well allocated portfolio will afford you protection and offer you growth even during times of volatility.
- Freedom from timing the market
Consider timing a single asset class’s market. Those investors who try to actively time the equity markets can testify to its volatility. Now imagine timing the performance and market movement across different asset classes. Investing without stress is not hard to achieve, if you remove timing the market, or markets, and implement a disciplined strategy.
Asset Allocation is also different for investors with different goals and time horizons
For somebody with a short term investment horizon i.e. 3 – 5 years or less, it is advisable to allocate more funds towards fixed income and allocate fewer funds in your portfolio to riskier assets such as gold or equity.
For a medium term investment horizon i.e. more than 5 years, your allocation to riskier asset classes can increase, to take advantage of the higher risk-reward ratio that these classes offer. However, maintain a healthy allocation to fixed income with low risk to balance your portfolio as your investment horizon reduces.
For a longer term investment horizon i.e. closer to 10 years, you can allocate a higher proportion of your funds to riskier asset classes, to take advantage of the power of compounding in your longer time horizon. Maintain some exposure, if not too high, to fixed income and gold to provide safe, fixed returns and to hedge against the risks of equity and inflation.
In the third of this series of “Introduction to Asset Allocation”, we explore the challenges that arise in the process and the key questions an investor must ponder upon to build a solid investment portfolio: Part III.