When it comes to investing, one of the most worrying factors for investors is the risk involved. The word itself has come to be associated with the idea of ‘loss’ or ‘erosion of wealth’. But not all risk is bad. Some risk is essential to increase the return potential of your investments. The trick is not to avoid risk, it is to manage it. And the most efficient method of risk management is a good asset allocation strategy.
Like the adage goes, “Don’t put all your eggs in one basket”.
Asset allocation refers to spreading out investments across various asset classes such as equity, debt, and gold, among others. The point of diversifying your allocation is to evenly distribute your risk. In other words, asset allocation helps in cancelling out the risk posed by one asset class with opportunities in another. It must be noted here that diversification can also happen within an asset class. For instance, within equities, an investor can invest across large, mid or small caps to better manage the risk. Investors must consider their risk appetite and financial goals before choosing the appropriate asset mix.
Benefits of Asset Allocation in Mutual Funds
It is seen that all asset classes do not move in tandem at any given point in time. Due to the unpredictable nature of market movements, it is necessary that an investor has their investments spread across asset classes to maximise return potential and lower the overall risk. With equities, investors could experience volatility in the short term but over the long-term equities could help in building wealth as the return potential is the highest over the long run in equities. With debt, there is usually lower volatility, but staggered returns. Gold can be used to hedge overall risk as it is a safe haven investment.
In a mutual fund portfolio, investors can choose to invest across fund categories within equities, debt, and gold mutual fund schemes. Since equity investments are usually for the long term, investors can choose to invest in equity mutual funds through the online SIP route and top it up, if they wish to with lumpsum investments as and when they can. The SIP route of investment can further help in mitigating risk.
Debt funds on the other hand can be looked at for short-term goals. Since returns in these funds are comparatively lower and protection of capital is the main purpose, lumpsum investments would be preferred. However, investors can look at SIPs in debt funds, especially in duration-oriented or credit risk-oriented funds where the risk is slightly higher.
How to Decide an Ideal Asset Allocation for Mutual fund?
An ideal asset allocation is decided on the basis of the financial goal, risk appetite, and life stage, among others. The first step towards asset allocation is the identification of the goal, whether it is short or long term as well as the risk appetite. Financial goals at different stages of life calls for different asset allocation strategies for better risk-adjusted returns.
For short-term goals, the asset allocation should be such that it minimizes risk and maximises return potential along with capital protection. For medium-term to long-term goals, asset allocation should be based on the risk appetite of the investor.
In the early stages of life our risk appetite is the highest, so our portfolio could be made of largely equity mutual fund schemes since wealth creation is the main goal over the long term. This is the stage when you look at long-term plans such as purchasing a house, planning children’s education, retirement planning, tax planning, among others. There should be some exposure to debt but that can be a small portion of the portfolio.
As investors mature in age, the asset allocation should move towards less riskier products. Investments made in equities at the early stages should be continued but incremental investments could be done in hybrid mutual fund products which have exposure to both equity and debt, and sometimes even gold. The idea here is to create a balanced portfolio which in equal parts provides returns and safety of capital. At this stage of life, the investors risk appetite is high enough but not as high as earlier.
Investors moving towards retirement age should choose an asset allocation which is high on safety of capital and less risky. At this stage, a large portion of the portfolio should start moving to debt mutual funds. Equity investments should be a small portion and for a period of at least five years. As the investor moves closer to the retirement age, this equity exposure should also reduce. Post-retirement, it is best to avoid equity exposure altogether. In fact, investors can choose an STP or SWP facility to withdraw equity investments and establish a regular income flow for themselves.
Irrespective of the stage at which an investor is at, asset allocation is a must in order to optimize overall portfolio returns and diversify risks as portfolio returns and risk go hand in hand. By following an asset allocation strategy based on an investors’ life stage, an investor can build a safe and secure financial future for themselves.