What is Asset Allocation: Definition, Benefits and Strategies?

Strategic asset allocation strategy determines the investment allocation across different asset classes based on the investor’s needs like age, financial responsibilities, current assets, risk tolerance, etc. One of the simplest methods of strategic asset allocation is based on age and commonly known as age-based asset allocation. This method can be summed up using the below formula:

(% of Equities in Investment Portfolio) = 100 – (Age of Investor)

So, if an investor is aged 45 years, the ideal equity allocation as per strategic asset allocation will be,

% of Equities in Portfolio = (100 – 45) = 65%

Moreover, as the age of the investor increases, the proportion of equity in the investment portfolio will decrease. So, the equity allocation of a 50-year old investor will decrease to 50% and so one. The key benefit of this strategy is that it is easy to understand and promotes long term investment in key asset classes to help with wealth creation.

Some investors consider the strategic asset allocation strategy to be quite rigid and for such individuals, tactical asset allocation can be a viable alternative. The strategy of tactical asset allocation attempts to capitalize on market movements and generate profits in the short-term while ensuring that the overall investment portfolio stays on track to achieve the long-term investment goals.

An example of this strategy would be increasing the equity allocation of the portfolio temporarily when equity markets are witnessing a downward trend. Subsequently as equity markets recover, the investor sells the extra equity allocation for a profit and rebalances the investment portfolio by increasing allocation towards other asset classes like debt mutual funds, gold investments, etc.

As you can see, to successfully implement this strategy, the investor is required to be well-versed with various aspects of investments. This is important so that one is able to time his/her entry and exit from different asset classes to benefit from market movements and maximize profits

In one way, dynamic asset allocation is similar to tactical asset allocation as both strategies aim to generate higher returns by taking advantage of changing conditions of equity and debt markets. There is however a key difference – while tactical asset allocation involves repeated manual intervention by the investor, dynamic asset allocation automates the process without any preset allocation towards different asset classes.

So, investors engaged in dynamic asset allocation have the flexibility of changing their portfolio allocation from 0% to 100% across any of the chosen asset classes based on market movements. What’s more this asset allocation strategy usually involves 3 or more asset classes in order to diversify the investment portfolio. Key asset class options that are available to investors when implementing the technique of dynamic asset allocation include – equities, debt, gold and real estate.

TAs asset allocation ensures diversification of your investments, you do not have to depend on a single type of investment to achieve your financial goals. This reduced reliance on any single asset class or investment leads to a decrease of the overall risk in your investment portfolio.

All investments are prone to some volatility depending on prevailing market conditions. But, while you might not be able to completely eliminate volatility from your portfolio, asset allocation can help decrease and control it to some extent. This is because, as you diversify your investment across different types of assets, changing market conditions would prove beneficial for some of your investments so that overall portfolio volatility is reduced.

Market-linked investments like stock, bonds and mutual funds go through cyclical periods of high and low returns even periods of negative returns at times. One of the key benefits of diversifying your investments across multiple asset classes like equity, debt, gold, etc. is that you maximize your returns during different market highs and ensure downside protection during market lows. This way your investment portfolio will be ideally placed to outperform the broader market under various conditions.

One invests money in order to achieve key financial goals whether it is a vacation, down payment on a new car, buying a new house, retirement planning, etc. Through asset allocation, it is possible determine which basket of investments is ideally suited to achieve such specific investment goals. This is because implementing your chosen asset allocation strategy will help you stay on course to help you reach your specific financial goals.

Age of an investor plays a critical role in asset allocation as it is key to determining how long an investor can stay invested. As a rule of thumb, younger investors can invest for longer periods so they are minimally impacted by short term volatility of their investments. This makes it possible for younger investors to allocate a large proportion of their investment towards equities so that they can focus on long-term wealth creation.

On the other hand, investors who are closer to retirement typically have greater financial responsibilities and need to have easy access to funds in a relatively shorter term. For such investors, the proportion of equity investments in the portfolio may need to be limited while a greater proportion of assets might need to allocated towards other asset classes that have relatively less short-term volatility like debt and gold, which can be achieved through specific types of mutual funds .

Risk Tolerance is defined as the ability of an investor to tolerate a loss and risk is an integral part of any investment. Investors who have high risk tolerance can take a greater degree of risk to the principal amount invested and focus on earning higher returns. On the other hand, investors with lower risk tolerance tend to prefer more conservative investments including guaranteed return options like fixed deposits and ecurring deposits.. This is one of the key reasons why risk tolerance of an investor determines the proportion of assets that is invested in different asset classes.

One of the key factors that impact investment tenure is the investor’s goal for making the investment. If one is investing for short periods of up to 1 year, capital protection might emerge as the primary need for the investor as compared to wealth creation. In such cases, investments that have low volatility in the short term like bonds and other debt instruments would emerge as the preferred investment option. On the other hand, asset allocation towards equity-oriented investments would tend to be higher if one is investing for a tenure of 5 years or longer. This is how investment tenure impacts the allocation of the investment portfolio across different asset classes.