Asset Allocation Guide

Asset allocation is the process of dividing our investments among different kinds of asset classes (equity, debt, commodity and cash) to minimise our risk, and also to maximise return at the given level of risk. The reason asset allocation works is because every asset class exhibits its own characteristic of risk and return that is different from others. The article provides valuable tips about how you should allocate your assets

The coronavirus pandemic has reinforced one of the greatest lessons of investment. You cannot predict the short-term returns of any asset class. We saw in the last calendar year how the returns from equity first saw a dramatic fall in the first quarter and then an equally dramatic recovery from thereon. In the same duration, some of the long-duration bond funds generated double-digit return. Such volatility in returns may lead to a wrong decision by investors when it comes to entry and exit from their investment, which can ultimately jeopardise overall portfolio returns. Diversification of your investment may help you to avoid such decision.

Not long ago diversification was simply to ‘avoid putting all your eggs in one basket’. The argument was that in such a scenario the range of possible outcomes becomes very wide. If you invest in a single asset you might win very big but you also face the possibility of losing very big. So if you had only invested in equity you would have witnessed the value of your portfolio declining by more than 40 per cent last year in a span of just two months. Such a large drawdown may have led to panic and you would have sold your investment at a wrong time.

This is not the first time we have seen such a large fall in the equity market and definitely not the last one. In the years 2005, 2006 and 2007 we saw the equity market giving return of more than 40 per cent every year. Nevertheless, the fall in the equity market in year 2008 would have wiped out half of your portfolio value. So if you had invested Rs 100 at the start of 2005, at the end of 2008 it would have become Rs 144.5 giving you annualised return of 9.5 per cent.