Asset Allocation Strategy: Four Reasons Why It Is Important

Asset allocation strategy is the process of distributing investments across various asset classes like equities, gold, cash equivalents, fixed income securities etc. The goal is to balance the portfolio’s risk and rewards as per your risk appetite and time horizon of financial goals. Asset allocation strategy plays an important role in financial planning and has greater impact on your investment returns over the long term than market timing and security selection. However, most of the retail investors fail to understand its importance and select mutual funds based on their recent performance. 

Here are 4 advantages of following asset allocation strategy:

Helps generate optimal returns

Each asset class has its own distinctive features. Few of them may score high on returns while others score high on income certainty and capital protection. For instance, equities can be very volatile in short term, but it yields higher returns than other asset classes over the long term. On the other hand, fixed income securities offer higher income certainty and capital protection while underperforming equities over the long term. Thus, in a portfolio consisting of both debt and equity instruments, the equity component will yield higher returns over the long term while the debt component will provide stability to the portfolio during increased volatility in the equity market in the short term.

Minimises risk to your overall portfolio

Some asset classes have negative correlation as far generating returns is concerned. Market conditions can lead an asset class to register strong gains while denting the value of another asset class. Thus, diversifying investments across asset classes with negative co-relation can offset the losses from a falling asset class through the gains made in the appreciating one. 

For instance, equities and fixed income instruments often have negative co-relation. An economic decline or falling corporate profits may weaken equity markets, which might lead the central bank to reduce policy rates for lowering borrowing costs and thus, reviving the overall economy. Reduced interest rates in such a scenario will lead to an appreciation in the bond prices. Hence, if you have both debt and equities in your portfolio, the losses from your equity investments will be counterbalanced by  capital appreciation of your debt constituents. Likewise, equities and gold are inversely co-related.  During global uncertainties, when equities face a downfall, appreciation of your gold instruments will cover-up your losses to a certain extent.

Adequate liquidity

Liquidity is one of the major factors to be considered while investing. It refers to the ease at which you can convert your investment into cash. An appropriate asset allocation strategy would help maintain enough liquidity in your portfolio by parking a portion of your surplus in safer asset classes to meet financial emergencies or short-term goals. For instance, parking your emergency fund in equities may propel you to redeem it at a loss during falling markets, to meet financial emergencies. Instead, you must park your funds in ultra-short and short duration debt funds to ensure capital protection while generating stable returns.

Portfolio rebalancing

Asset allocation strategy would help you rebalance your portfolio according to the changes in your risk appetite and financial goals. For example, as equities can be very volatile in the short term, you should redeem equity investments nearing maturity and park the proceeds in fixed income instruments to consolidate your gains. Similarly, as equities outperform other asset classes over the long term, you may continue investing in equities for long term goals. 

Portfolio rebalancing can also help bringing back your portfolio to the original asset mix. Differing returns generated by various asset classes may lead your portfolio to have an altered asset mix after a certain period of time.  For instance, extraordinary returns generated by equity mutual funds during bull market conditions can drastically decrease the proportion of your debt investments in your overall portfolio. If such changes in your asset mix alters your risk appetite significantly, you can redeem a portion of your equity investments and invest the proceeds in debt instruments to restore the original asset mix in your portfolio.

Naveen Kukreja

Guest Author Naveen Kukreja is CEO and co-founder of Paisabazaar.com. He studied engineering at Delhi College of Engineering and holds a postgraduate diploma from IIM Calcutta