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The importance of the right asset allocation in finance is in the well-known English phrase – do not put all your eggs in one basket. The financial markets are ever-growing and fluctuate more than often. The market fluctuations or volatility, be it sudden or excess, can harm the investors’ ROI (Return on Investment). During such times of uncertainty, it is crucial to protect the capital and still achieve reasonable returns from the investments.
A short note on risk:
Risk matters the most in volatile markets. Equity is the best-performing asset class in the long term because of the risk involved with volatility. Hence those who can manage risk through asset allocation are rewarded well in the long term.
What is asset allocation?
Investors can manage risk and reward by distributing their investments in different asset classes and this is known as Asset Allocation.
Understanding Asset Allocation
Capital appreciation is usually fuelled by the performance of domestic equities and the steady returns are produced by investments in debt whereas investing in global equities gives investors an option to diversify geographically and make best use of significant trends. Such an approach that involves investment strategies in both cost and tax ways provides investors with wide verities of assets within each asset class. The investors can also consider investing lump-sum amounts on these strategies.
What makes asset allocation effective is the fact that every asset class reacts to market pressures in different ways. For example: In general, the equity market does extremely well in the expanding phase. Such a phase is characterized by low-interest rates, a jump in money supply, and increasing demand.
On the other hand, during the shrinking or contraction phase debt generally performs well. The characteristics of such phase are inversely proportional to the equity phase like- rising interest rates, decreasing money supply, and easing demand.
Hence, if the investment strategies in one asset class, say equity are underperforming, the presence of debt in the other asset class which may be comparatively performing better will offset the risk in the portfolio.
Although a multi-asset portfolio is a ready solution there is no one-size-fits-all solution that suits all investors with a variety of objectives.
That’s why assigning your investable funds across asset classes like equity, debt, and gold, which have narrow co-relation to each other in terms of performance of asset classes, based on your risk profile is one of the best forms to beat the market volatility.
Challenges an Investor Faces
Asset allocation, however, is not an easy task and requires constant rejigging across asset classes in a tax-efficient manner to avoid a portfolio’s bias towards one particular asset class.
So, is there a perfect asset allocation strategy?
The foremost thing for a prudent investor to do before an asset allocation is to keep a financial backup and park at least 12 months of expenses as an ’emergency fund’ in a risk-free safe instrument, say in an SB (Saving Bank) or FD (Fixed deposit).
Once the aforementioned emergency fund is taken care an investor can carve their portfolio comfortably. The leftover money can be invested by splitting between 80% to equities and 20% to gold.
In the present scenario to utilize the potential of the Indian equity market`s upside expansion despite the volatile fluctuations created by higher inflation, rigid monetary policies, and global economic slowdown; the market participants can allot 90% to equities and 10% to gold or debt. Another way could be to allocate 90% to equities 5% to gold and 5% to debt. This sort of asset allocation with the sound backup of an emergency fund can profoundly limit portfolio losses when equities stumble in recessionary circumstances.
Conclusion
Investing in an asset class like equity where the volatility is given, you as an investor can mitigate risk meaningfully by SIPs (which is an effective way to beat the volatility over long periods) or lump sum investment and aim to strike a balance between risk and reward established on one’s risk appetite, investment timeline, and financial goals.
Therefore, with a long-term approach and staying strictly disciplined in one’s own asset allocation and investment strategies, you can successfully steer clear of market volatility and accomplish your financial goals.
