Asset allocation sounds like a complicated, technical financial term. The jargon brings our minds to a stop when we are reading something that can otherwise be very useful for us. Let’s try to simplify this and understand how it impacts our investing lives. In fact, most of us indulge in some form of asset allocation without really thinking about it. After understanding what it is and how it affects outcomes, you can make conscious asset allocation choices that will stand you in good stead for years to come.
What is it?
Asset allocation is nothing but spreading your money and investments across different financial securities and physical assets. Let’s say you have some amount which you invested in fixed deposits, some amount that you bought gold with, a flat you have invested in and put up on rent and then some mutual funds investing in equity. If you add all these amounts, that becomes your total investible portfolio. The portions invested in each of the assets above demonstrate your asset allocation.
Often asset allocation is an outcome rather than a conscious choice. We invest first and think later. However, if you want to achieve your life’s goals or want to be closer to achieving them to the best of your ability, then you need to reverse this process. Asset allocation should be a conscious choice that guides you on where to invest your money on the basis of your life goals.
Your conscious asset allocation
While investing the focus is often on the product, whereas, it’s a lot more beneficial to focus on the asset allocation. Products will follow and fill in the gaps. The first step is to start thinking about your life goals and your financial goals, things you want to achieve and things you have to achieve. For example, supporting your child for their higher education is a financial goal you have to achieve. At the same time, you may have a life goal of sponsoring a sports centre for the less privileged children in society. There are bound to be other big and small goals like retirement planning, home building or restructuring, buying the next car and travelling in the summer break. These are just some examples, every individual and family will have a variety of different goals.
In order to make your money work towards generating passive income through investments, which can then help you finance these goals, your asset allocation needs to be conscious. For example, if most of your large-sized life goals are at least eight years away putting your money in low yielding fixed deposits or illiquid property will not be beneficial. Similarly, putting your money with which you are planning an international family getaway two years later, in a mid-cap equity fund or stock will also not be useful.
This means, instead of simply picking an investment, first think about what you want to achieve and then decide where and how much to invest. If the bulk of your financial goals require capital protection and safety, you will not do well to have an asset allocation that’s skewed towards assets like real estate or equity.
The conscious choice around asset allocation is also about how much risk you are taking in your portfolio. Asset allocation which is aligned with your life goals also needs to be aligned with your risk-taking ability.
What is the impact?
While we focus on products, in reality, it is the asset performance that matters more. Fixed return products like fixed deposits, bonds, savings certificates, pension fund investments all fall in the fixed income category. While individual product returns may differ, returns are guided by the general interest rate cycle of the economy. At the moment, the rate cycle is trending lower and the benchmark Repo rate is low. As a result, returns in the form of interest pay-out from most fixed income options have also fallen or been lowered.
If you keep thinking of fixed deposit just as a product rather than thinking about what the asset class is doing, you may miss out on the balance you need to have in your portfolio to achieve your goals and maybe stuck in a low rate cycle.
Usually, it is recommended to have a portfolio of products from across different asset classes which behave in an opposite manner. For example, when rates are low equity prices tend to work better. By balancing your portfolio with assets that behave differently, you can achieve a balance. At a time when fixed income is not performing, the equity side of your portfolio is there to deliver returns and when equities are doing poorly, the stable returns from fixed income provides the needed cushion. By consciously focusing on asset allocation you can enhance your portfolio to be more aligned with your goals. Remember, you are doing it already, you just need to make it more focused and a conscious effort.