There is often excessive focus on stock or mutual fund selection, with every advisor claiming superior returns.
However, before diving in, consider these facts: A study titled “Determinants of Portfolio Performance,” published in the Financial Analysts Journal, analyzed data over ten years and found that asset allocation accounted for 93.6% of the variation in a portfolio’s quarterly returns. Only 7% was attributed to stock selection and other factors.
Numerous other studies corroborate these findings. Regardless of market changes and exact percentages, the key takeaway is that asset allocation is crucial to determining your long-term returns. Let's learn the asset allocation!
Learn What is Asset Allocation ?
Asset allocation involves deciding how much of your investment should be distributed across various asset classes, such as equities, bonds, fixed deposits, cash, gold, and property. Each asset class has distinct risk and return characteristics and typically low correlation with one another. Proper asset allocation determines the percentage of your investment allocated to each type of asset.
Why is Asset Allocation Important?
The decision on asset allocation is vital for long-term financial success. It is a personal decision influenced by three critical factors:
Investor's Risk Behavior: Understanding your attitude towards risk through behavioral questionnaires can help determine if you are risk-averse, moderate, or risk-seeking.
Investor's Risk Capacity: This is about your actual ability to take on risk. Even if you are comfortable with risk, factors like your financial situation and time horizon for the investment play a crucial role.
Investor's Risk Need: This considers whether you actually need to take on risk to meet your financial goals. If low-risk investments suffice, it's prudent to avoid unnecessary risk.
In general, investors should allocate their investments among equity, debt, and cash according to their individual needs and risk profiles. Here’s a summary of the risk-return profile for these asset classes:
Equity: High risk, high return
Debt: Moderate risk, moderate return
Cash: Low risk, low return
You can use the following indicative returns chart as expected returns from these asset classes
| Risk | Return | Expected Return |
Equity | High | High | 10%-12% |
Debt | Moderate | Moderate | 6%-8% |
Cash | Low | Low | 2.5% - 3.5% |
To determine your asset allocation, start by considering your required rate of return. For example, if you have ₹10 lakh today and aim to accumulate ₹25 lakh in 8 years for a down payment on a new house, you need to invest at an annual return of 12.14%.
Here's how to calculate the required return:
Alternatively, you can use an Excel sheet for this calculation.
Input your current investment, target amount, and investment period to determine the required rate of return. This method assists in setting realistic investment goals and selecting an appropriate asset allocation strategy.
Determining Asset Allocation
Given your assumptions, you need an asset allocation of approximately 90% in equity and 10% in debt to achieve an expected return of around 12.14%. This is your first step in asset allocation. However, does a 90% equity allocation align with your risk profile? If not, you may need to adjust your goal or extend your time horizon.
Rebalancing Portfolios
Rebalancing portfolios involves ensuring your asset allocation remains consistent. For example, if you hold a portfolio of 80% equity and 20% debt, and equity markets surge, your equity percentage will exceed 80%. You should then sell some equity and invest in debt to restore balance.
Frequency of Rebalancing
A crucial point to consider is the frequency of rebalancing. Rebalancing too often can lead to higher taxes and increased portfolio risk. Ideally, rebalance equity investments once a year and debt investments once every three years. However, if market conditions demand, take action sooner. Your Goalstox advisors can guide you in making these decisions.
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