Creating wealth means different things to different people. For some it could mean attaining financial freedom, for some it could mean carrying out their financial responsibilities with ease and for some, it could mean leaving a legacy behind. Irrespective of what wealth means to you, each one of you makes investments in order to create this wealth and fulfill your dream.
However, wealth creation is not about making investments for the highest possible returns but about making investments to get consistent returns by following the correct investment strategy. It is a long-term process and needs to be done wisely. One of the most important aspects in the process of wealth creation is asset allocation.
Just as we need to have a balanced diet to stay healthy, similarly we need a balance in our investments to stay wealthy. Asset allocation helps bring about that much-needed balance in your investments.
What is asset allocation?
Asset allocation, basically, is the process of spreading your investments in various types of assets such as equity, debt, gold, real estate, cash etc. in varying proportions in your portfolio so that at any given time the return generated on your investment is not dependent on the performance of one asset class. Having a healthy mix of various asset classes at the time of constructing a portfolio will help deliver consistent returns and reduce the overall risk of your investment.
Essentially, asset allocation is based on the principle that different asset classes perform differently in different market conditions. For example, in times of economic downturn, the equity markets tend to fall thus generating negative returns. However, in this period as the government tries to revive the economy by lowering the interest rates, the bond prices go up, thus, increasing the returns from debt investments. So, if you have both equity and debt investments in your portfolio, then gains from the debt investments will help set-off the losses from the equity investments.
The main aim of asset allocation is to obtain optimal diversification so as to maximise the returns and minimize the risks associated with the investments. So, once you diversify your portfolio in different asset classes, you have reduced the overall risk of your portfolio.
How does asset allocation work?
Just like all other investment decisions, the process of asset allocation, too, requires time and effort of the investor and there is no “one size fits all”. So, before you get into the nuts and bolts of how to best allocate your investments to suit you there are few important aspects which you need to take into consideration which include:
Before making any investment decision it is important to have a clear understanding of the financial goals you wish to achieve. Financial goals can be anything such as buying your dream house, funding your child’s education or retirement planning. Your asset allocation would be determined depending on the amount of corpus you wish to create for your goals.
The next thing to consider is the time horizon that you are looking at for your investment and for how long can you stay invested. If you are a young investor with no major liabilities and most of your goals are long-term in nature, then you can look at a portfolio with a higher proportion of allocation in equities. However, if you are inching close to your retirement and your main objective is the protection of accumulated wealth with a regular income, it is advisable to have higher allocation in debt.
The risk appetite for each investor is different and dependent on multiple factors such as age, income level, lifestyle and personal circumstances. If you are willing to take higher risks then you can invest in high risk-high return investment assets. However, if you are conservative in nature, investing majorly in low-risk assets is advisable.
Thus, the proportion of investment in various asset classes to create an optimal portfolio is primarily dependent on your response to the above questions. For example, equities provide higher returns but also have a higher degree of risk attached to them. Similarly, investments in bonds provide low returns but also carry lesser risk.
Moreover, wealth creation is an ongoing process and not a one-time activity. With the passage of time, the proportion of investments in various asset classes keeps changing as per the performance of the assets. Hence, it is important that you review your portfolio regularly and ensure that you rebalance your portfolio so as to maintain the optimum asset allocation
Also, your investment needs are dynamic and not static. In order to keep up with your changing investment needs you may have to bring about changes in the asset allocation of your portfolio.
Even though asset allocation is one of the most important concepts in the process of wealth creation, a large number of investors fail to embrace it. A well-constructed portfolio can significantly lower the volatility of your portfolio and enhance the returns. Asset allocation is an important factor which can help you achieve your investment goals and help in wealth creation. It is extremely important that you pay attention and build a portfolio after taking into consideration your individual financial goals, investment time frame and risk appetite to create an optimal portfolio.