Movie Case Study
The scene shows Raju (played by Rajpal Yadav) having a conversation with his wife Seema. He is talking about how he will allocate Rs. 1,00,000 when he wins the lottery. He decides that he will allocate Rs. 25,000 for the repairs of his house, Rs. 25,000 for his son’s education. Another Rs. 25,000 for his wife’s jewelry and the leftover on his vehicle.
In this blog, Learning Perspectives will explore the meaning of asset allocation.
What Is Asset Allocation?
Similar to the scene that you saw, asset allocation deals with the division of money in different baskets. Asset allocation is used as an investment strategy. When an investor invests money in securities, he has to decipher how much money needs to be allocated to various funds. That means knowing how much percentage needs to be allocated to each fund.
For example, if the investor has Rs. 1,00,000. He needs to allocate resources strategically. This is dependent on his risk appetite, investment duration, age, and cash/ income inflow.
If the investor is in their 40s or 50s, then their investment goals would be very different from a youngster who is in their 20s or early 30s.
With age, many investors’ risk appetite changes too. Some investors are generally risk-averse while some are risk-takers. There are moderate risk-takers too. These investors mostly want to invest 50% in the debt market and 50% in equity markets.
As a person ages, generally, their risk appetite decreases, and many people who are in their 40s would now want guaranteed returns and want to play safe or conservatively.
Hence, such a person would balance his portfolio, by investing equally between debt and equity. The equity market is considered risky in comparison with the debt market. The debt market includes instruments such as bonds, government-backed securities such as PPF, NPS, fixed deposits, etc.
Understand Asset Allocation with a Video
The return of the stocks or securities depends on the state of the economy. Diversification is the main strategy through which risk can be mitigated in the portfolio. When the portfolio has one security, the risk of the portfolio is the risk of the single stock included in that portfolio.
How to Diversify Portfolio?
As an investor, I can choose to invest 60% of the money in shares and 40% in government-backed security. Both offer different risks and returns. In the equity sector, the return might be higher which means that the risk is high too while in the government-backed security both risk and return are lower ensuring safety. So a portfolio can look like the below:
This individual is a moderate risk taker, she has allocated 40% of the portfolio to the debt market i.e. fixed deposit and IDFC bonds. While 60% of the allocation is in the equity market i.e. Reliance and ONGC shares. Bonds are long-term in nature and the time horizon and return of each instrument differ. If the individual wants to purchase a vehicle in 2 years, then allocation will differ according to their goals.
Hence, selecting the right securities and their allocation in a portfolio is the most important aspect of an investment strategy.