Asset allocation is the process of distributing your investments across various asset classes, such as equity, debt, gold, cash, etc., according to your risk appetite and the time horizon of your financial goals. Your asset allocation strategy will have a greater impact on your investment returns over the long term than security selection and market timing. However, most investors fail to realise its importance and instead select mutual funds on the basis of their recent performance. Here are the top benefits of following an asset allocation strategy.
Reduces the risk of your overall portfolio
Diversification across various asset classes is one of the primary means of reducing the risk and volatility of your investment portfolio. The volatility of a diversified portfolio depends on the volatility of its constituent asset class and often, the correlation between their volatility is negative. Market conditions can lead a particular asset class to register significant appreciation while denting the value of another asset class. Thus, inclusion of asset classes with negative co-relation offsets the losses from a falling asset class, with the appreciation of the rising one.
For example, equities and debt instruments usually have negative co-relation. A weakening economy and declining corporate profits leads to fall in equity markets. The central bank tries to revive the economy and reduce the borrowing costs by decreasing policy rates, which causes the bond prices to appreciate. Thus, if you have both equities and debt instruments in your investment portfolio, the losses from equity will be offset by capital appreciation of your debt component. The same thing happens with gold and equities as gold appreciates during global uncertainties while equities take the maximum hit.
Helps earn consistent returns
Each asset class comes with a unique proposition. While some score high on returns, others would score high on safety and certainty of income. For example, while equities offer highest possible returns over the long term, fixed income instruments offer stability and certainty of income. In a diversified portfolio with significant exposure to both equity and fixed income, the equity component will help generate higher returns for the portfolio while the debt will provide stability during volatile market conditions.
Maintain adequate liquidity to meet emergencies
Liquidity of an asset class refers to the ease with which it can be converted into cash. It is one of the major factors to be considered while making investment decisions. Asset allocation strategy will help you maintain adequate liquidity in your portfolio by earmarking a portion of it in safer asset classes for meeting financial emergencies and short-term goals.
Parking your emergency fund in equity funds may force you to redeem them at a loss for meeting financial exigencies during market corrections. Instead, emergency funds should be ideally parked in ultra-short and short-term debt funds for ensuring capital protection.
Allows portfolio rebalancing
Your asset allocation strategy will allow you to determine your optimum asset mix and rebalance it according to the time horizon of your financial goals. For example, as equities can be very volatile in the short term, you should consider redeeming equity investments made for financial goals nearing maturity and park it in debt funds to consolidate your gains.
Similarly, as equities outperform other asset classes over the long term, the asset allocation for long-term financial goals can continue to remain equity-heavy as it will get more time to recover from the volatility of equity markets.