3 reasons why you need asset allocation?

Your goals should be in the forefront of your mind when you begin the financial planning process. After that, you work backwards to create a strategy for achieving these objectives. Of course, merely saving in a bank savings account won't help you reach your long-term financial objectives.

Simply said, the returns won't be sufficient. Allocating money to riskier ventures and taking measured risks are what you need to accomplish. That will guarantee that over time, both your principal and your returns will generate returns.

There are many twists and turns in our investment journey as it develops in different ways. We have several goals with various return requirements in a setting with shifting risk profiles. If we as investors only invest in one asset class today and then go to bed, we are probably in for a harsh awakening tomorrow.

The assets we invest in have different risk/return profiles, much like our investment journey. We must concentrate on "Asset Allocation" if we want to make sure that we have the best chance possible of achieving our objectives.

Introduction to Asset Allocation

The process of allocating your investments among various assets, such as stocks, bonds, and cash, is known as asset allocation. The choice of how to allocate your assets is a private one.

Depending on how long you have to invest and how much risk you can bear, the allocation that is ideal for you changes over the course of your life.

Considerable factors include:

• Time Scale

Your time horizon is how long you need to invest—in months, years, or decades—to reach your financial objective.

Longer-term investors might feel at ease making riskier or more variable investments. People who have a narrower time horizon could choose to assume less risk.

• Risk Acceptance

Your capacity and readiness to lose part or all of your initial investment in exchange for potentially higher returns is known as your risk tolerance.

• Risk versus reward

Risk and rewards are inextricably linked when it comes to investing. The adage "no pain, no gain" perfectly captures how risk and reward interact.

Risk exists in all investments to some extent. Risk-taking is rewarded with greater possibility for better returns.

Various strategies of asset allocation

• Asset allocation strategy: This approach is often referred to as static asset allocation. Target allocations for various asset classes serve as the foundation for strategic or static asset allocation.
  
  Regardless of the state of the market, you should adhere to the target asset allocation ranges when making strategic asset allocation decisions. However, to return the asset allocation to the intended level, regular rebalancing is necessary.
  
  For instance, if you allocate 60% of your assets to stocks, which offer a 15% return, and 40% to bonds, which offer a 5% return, then the portfolio's mean return is 11%.
  
  

• Dynamic asset allocation: This approach is designed for active investors who keep a close eye on their portfolio. With this asset allocation method, you adjust your asset mix in response to the state of the market.
  
  For instance, under some dynamic asset allocation schemes, if stock prices rise, you would reduce your equity allocations and increase your debt allocations.
  
  You should increase your equity allocation and decrease your debt allocation when the value of equity declines.
  
  When markets are correcting or when they are booming, the user may also move winnings from a volatile asset to less risky assets or move to riskier ones.
  
  

• Tactical asset allocation: An investor can occasionally stray from their primary strategic or dynamic asset allocation in order to take advantage of market opportunities.
  
  Market timing is a key component of tactical asset allocation, which calls for extensive investment knowledge.
  
  In this sort of allocation approach, the investor often maintains a low level of activity, and once short-term gains are realised, the portfolio is rebalanced to its initial composition.
  
  

What different asset classes or categories are there?

The majority of financial analysts concur that there are four major groups of asset classes. Namely:

• Fixed Income: One of the most well-known and traditional types of investing possibilities is fixed income.
  
  It consists of government and corporate bonds, money market instruments, and corporate debt securities, among other things.
  
  These instruments make investments in debt securities that provide investors with fixed interest payments up until the plan's maturity.
  
  

• Equity: Shares of ownership held by publicly traded corporations are known as equity or stock. Equity has become very popular over the past ten years.
  
  Small-cap funds, mid-cap funds, large-cap funds, large and mid-cap funds, multi-cap funds, contra funds dividend, value funds, yield funds, sectoral funds, focused funds, and equity-linked savings schemes are other subcategories of equity funds (ELSS).
  
  

• Cash and cash equivalents: These asset types, also referred to as money-market instruments, are securities that are most suitable for short-term investing objectives.
  
  These instruments' liquidity is their main benefit. Treasury notes, commercial papers, money market funds, etc. are examples of extremely liquid cash equivalents that may typically be redeemed within 90 days.
  
  Investors can therefore easily access their money if it is placed in cash and cash equivalents.
  
  

• Real estate: This class of assets focuses on land, homes, condos, offices, factories, and other structures.
  
  These investments' tangibility is a key feature that sets them apart from other securities, which only exist in virtual or dematerialized forms.
  
  

3 reasons why you need asset allocation? 

• Minimizing risk and producing the best returns possible:

You will decide on your future investments based on your prior investing history or risk tolerance. If you've had successful returns in the past, you can become overly aggressive and just invest in stocks.

While if you have previously lost money trading in stocks, you may become too cautious and solely use fixed income instruments like fixed deposits and recurring deposits.

You see, your investment style may be excessively aggressive or too conservative depending on your past experiences.

And keep in mind that, while learning from the past is a positive thing, it is essential to adhere to an asset allocation strategy that is suitable for you in order to reach your financial objectives.

This will assist you in reducing investment risk and increase your confidence in accomplishing your financial objectives.

Many investors make ad hoc decisions about their investments in the absence of proper asset allocation.

In turn, this makes it challenging for individuals to decide whether the return on investments is adequate to meet their short- and long-term financial objectives.

Some investors make investments that are either excessively risky or too safe, and as a result, they are unable to generate acceptable returns.

On the basis of the investment risks you are incurring, proper asset allocation will assist you in calculating the amount of return you may anticipate from your assets.

• Assisting investments to fit with the time horizon

Your time horizon, together with your risk tolerance, plays a significant role in determining how you should allocate your assets as you work to meet your financial objectives.

Which asset class you should invest the majority of your investible surplus in will depend on your time horizon.

Just keep in mind that the more time you have to reach your financial objective, the more you can shift your asset allocation toward equities and away from debt.

Equities are thought to be particularly dangerous in the short term but less risky in the long run since they have more time to recover from periods of market turbulence.

Although debt is thought to be less hazardous, the returns generated by the asset class are typically not enough to outpace inflation, which is the major reason it won't help you reach your long-term financial objectives.

In order to reach your financial objectives, you will need to select the right combination of stock, debt, gold, real estate, and even cash based on your time horizon.

• Reduce taxes

If you are under the 30% tax rate and put all of your funds into fixed deposits to protect your investments, you are paying far too much in taxes when you might have rightfully been saving that money.

You should always assess investment returns from the point of view of post-tax returns on investments rather than pre-tax returns since post-tax return is the return that you actually receive in your hand.

Tax repercussions vary for each individual and for each scenario. The appropriate asset allocation will not only help you choose the best asset class, but also the best investment product, allowing you to reduce your tax burden.

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Conclusion

All asset classes don't move at the same pace or in the same direction, which is why having the proper balance is crucial.

Asset allocation distributes your hard-earned investment across several asset classes and gives you the ability to achieve higher returns while minimising the risk through diversification.

The benefits of smart asset allocation need careful consideration of a number of aspects, thus defining an ideal asset allocation is not as simple as it may first appear to you.

However, once a careful asset allocation is in place, you may relax knowing that you will generate a decent return, reduce risk and taxes, have enough liquidity, and even reach your financial objectives.