Asset Allocation

The various investment vehicles available to an investor offer a distinct risk-reward trade off. Asset allocation is in an investment strategy that seeks to create a balanced portfolio in which an investor holds different types of assets to actively manage risk and reward profiles.

Investments can broadly be divided into three asset classes, namely stocks, fixed income and cash. Of these, stocks are the most volatile, offer the highest returns and have the highest risk profile. Fixed income assets, such as bonds and certificates of deposit (COD), are less volatile, but offer more modest returns. Cash assets are the safest and represent the lowest risk profile.

Measuring Asset Allocation

Asset allocation depends on the income, risk appetite and circumstances of the investor. While a conservative investor would prefer a high ratio of fixed income investments in the portfolio, an aggressive investor would prefer to allocate more funds into stocks. The various factors that can influence asset allocation are:

• Time Horizon: This refers to the duration for which you can keep funds in your investment account. An investor who can sparecapital for a long term can opt for riskier, long-term investments, whereas those who might need cash in the near term can seek investments from which funds can be withdrawn without incurring losses.
• Risk Tolerance: This factor takes into account an investor’s ability to take risks. A conservative or risk averse investor would favor investments in which his/her capital is preserved, whereas an aggressive investor can risk losing his investment togenerate higher profits.
• Rebalancing: This factor involves resetting the proportion of asset class to the original ratio at regular intervals in casemarket fluctuations alter the initial distribution of money.

Importance of Asset Allocation

Each asset class represents a distinct level of risk and returns, and behaves differently with time. By spreading investments over different asset classes, an investor can protect the capital invested against significant losses in case the trends in a specific class move unfavorably. Diversification is a risk management technique that aims at distributing investments over various options. Diversification can be achieved by:

• Spreading investments over asset classes, such as stocks, mutual funds, bonds and cash.
• Spreading investments in one asset class over various options. For instance, investments in stocks can be spread over various sectors, such as software, telecommunications, pharmaceuticals and automobiles.
• Spreading investments across geographies, such as investing in stocks from different states and purchasing global bonds.