What is asset allocation? Why is it more important than security selection?

Why is asset allocation more important than stock selection? | Vrid
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We all heard about asset allocation when we started to invest or read about investing. But we passed right through it and looked into which stocks or cryptocurrencies we should invest in to become a crorepati.

Asset allocation sounds so boring that we ignore it like a disclaimer. But asset allocation should be the first step we take before investing. Without a proper asset allocation, we might become a pressure cooker. We will explain how.

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Buckle up, here we go!

What is asset allocation?

Asset allocation is the process of dividing your investment portfolio among different asset categories, such as equity, debt, gold, real estate, etc. The idea is to diversify the portfolio so that it is not overly exposed to any single type of investment, which can help to reduce risk.

In the beginning, most investors might start with a simple asset allocation of 60% in equities (stock market), 30% in fixed income (debt, PPF, EPF, etc.) and 10% in cash or cash equivalents. This would provide a balance of growth potential and income, while also having some liquidity for an emergency. 

The goal of asset allocation is to diversify investments to manage risk-return tradeoffs. We can adjust the allocation of assets in a portfolio based on an individual’s investment goals, risk tolerance, and time horizon.

As per Markowitz’s portfolio theory, efficient asset allocation aims for maximising the rate of return for a certain risk.

In simple terms, you wouldn’t use a helicopter to visit a grocery store, would you? If you can achieve a goal or return by investing in a lower-risk asset class, why would you invest in a high-risk asset class to achieve the same goal or return?

Different types of investments carry different levels of risk, and it’s essential to understand those risks and how they align with your investment goals before making any investment decisions.

And asset allocation is a strategy which can help plan your portfolio with minimised risk and maximised returns. 

Why is asset allocation important?

Let’s understand the importance of asset allocation with an example. We all know how good equity is to build wealth and beat inflation. 

Imagine, hypothetically, in 1990, a newbie invested all of his money in equity (Nifty 50).

We all have seen how volatile the equity market is. Some years it can give a return of over 20%, and some years it can hand out a return lower than -20%. 

Can you imagine how badly this -20% return will affect the portfolio, goals, and mental health of the newbie investor? It would be hell, right? This might turn him into a pressure cooker. He might get heartache and remove all of his money from the market. And tell others to not invest in the stock market again. (Have happened a lot)

And what would you do if you were in his situation? Since you are reading Vrid’s newsletter, you might not remove your money from the market and stick to your plan with some patience. 

If you did that, you would have received a return of 14.4% over 30 years (1990-2020). (We are using research by Capitalmind to prove our point. You can read their research here.

And let’s say another investor did some basic asset allocation and diversified his investments equally in Nifty 50, FD, gold and Nasdaq 100. He would have achieved a return of 14%.

By investing in Nifty 50 only, you outperformed the diversified investor by 0.4%. But your portfolio’s volatility was 25.7%, and his portfolio’s volatility was just 12.7%.

Is achieving the additional 0.4% return by taking almost double the risk worth it? 

No, right? By following a basic asset allocation, you could have reduced your risk by half and achieved similar returns. This is what asset allocation helps you do and why it’s so important.  

Also, in the past few years, a different asset class has been a winner based on its performance. It is very tough to pick a future winner. (Impossible without luck)

Ranking of all different assets based on their performance in India | Why is asset allocation more important than stock selection? | Vrid

Source: ET Money

Therefore, it is necessary to have a well-diversified asset allocation. Decide your portfolio asset allocation before you select which stock, fund, etc. to invest in and choose when to buy or sell them.

How should you diversify your portfolio?

Just because we gave you an example of equal investments in equity, fd, gold and US equity, doesn’t mean we recommend it. And past performance doesn’t guarantee future performance.

So, how should you decide your asset allocation?

Deciding your portfolio’s asset allocation involves considering several factors, including investment goals, risk tolerance, and time horizon. A combination of all these factors will help you decide the appropriate asset allocation. 

To start, you need to assess your goals like buying a car, a child’s education, retirement, and others. This will help you determine how much risk you are comfortable taking on and the types of investments that are appropriate for your goals.

Assess the time horizon for all the goals. How long you have until you need your money can also impact the asset allocation of your portfolio. For example, if you have a longer time horizon, you can take on more risk because you have more time to recover from potential unrealised losses.

If you want to buy a bike in the next 2 years, you can’t invest in equity. You need to invest in short-term debt investments.

A simple rule to follow is to invest in debt instruments for short-term goals (under 3 years), in hybrid investments for mid-term goals (3 to 5 years) and in equity for long-term goals (above 5 years). Remember, you have to rebalance your portfolio every year as your goal’s time horizon changes. Read more about goal-based investments here.

If you have started investing already, evaluate your current portfolio. Look at the current asset allocation of your portfolio, and determine whether it aligns with your goals, risk tolerance, and time horizon. If not, start making adjustments.

And you can get help from a fee-only financial advisor (RIA) for professional advice to help you determine an appropriate asset allocation for your portfolio.

Remember, asset allocation is not a one-time decision. It needs to be adjusted over time to reflect changes in your goals, risk tolerance, and market conditions.

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Still Curious?

If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.

Capitalmind – How to think about Asset Allocation in India – Part 1

Yadnya Investment Academy – 6 Factors to Decide Asset Allocation

ET Money – How to do Asset Allocation the Right Way

Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.

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DISCLAIMER: This newsletter is strictly educational and is not an investment advice or a proposal to buy or sell any assets. Please be careful and do your own research.

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