For a young investor, there would not be an important concept more than asset allocation strategy i.e. diversifying your investment portfolio with the right mix of mutual funds (MF), stocks, fixed deposits (FD), real estate etc. A great asset allocation strategy makes sure that your portfolio is well diversified and reasonably aggressive to help you meet your financial goals without undue risk.
Asset allocation is a strategy to provide a balance between the risk and reward by linking it to your financial goals and risk appetite.
Why is asset allocation so important?
The objective of asset allocation strategy is to get you a return on your investments while still managing the risk inherent with any investment option.
Because every asset class has a potential risk and there will always be a market risk involved with any of your investments say real estate and gold market which has seen a great run from 2003 & 2006 right till 2013 respectively, both the asset class is not generating any returns over the last few years. Similarly stock market and MF investments always carried a market risk, over the past few years, we have had a great run and returns from the market and barring few correction, may continue to see the same trend. The stock market also has its downfall or a dull period. If you look at the fixed instruments like FDs or PPF or PF, there also, the interest rates are falling for the last two-three years. So what is the moral of the story, you can’t eliminate this risk with respect to any investment product and you can’t even be wasting your money by keeping it in your savings account because you need to beat the inflation.
So, to mitigate the big risk of investing in any one or two products and getting exposed to the risk as mentioned above, you have asset allocation strategy which helps you reduce those risks, a smart asset allocation does help you avoid these risks.
Important factors to keep in mind for creating a good asset allocation:
A.) How long you need to invest?
B.) What is your risk appetite?
Age plays a very important role in deciding your portfolio and asset allocation. Like a young person aged less than 30, can take more risk with respect to his or her investments and can invest more in equities because he has a good amount of time to recover any possible setbacks.
It’s simple, your asset allocation will always look different when you say 25 years of age than when you are 70. In your 20s, you would likely to have minimum 20 to 30 years when you would be investing before you need all that money in return. Now, this enables you to invest in an aggressive portfolio which offers a higher growth & returns potential with a calculated higher risk. During the retirement phase or as you grow older, the time you have to grow your money will reduce and you won’t be able to afford a big loss. Hence this makes a young person take more risk and generate handsome returns, so the younger you are, better, you can create great wealth.
A simple example of an asset allocation strategy
You might have heard about the thumb rule to decide your asset allocation, i.e. as follows:-
100 your age = Stock market investments
So hundred years minus your age is equal to the percentage you need to invest in the stock market, So for example, if you’re 25, you need to invest minimum 75% in stocks and 25% in other financial instruments.
I suggest though this formula is oversimplifying the concept but let us just take the positive side of it which is the concept that your asset allocation should change as you grow older, period! Because once you do your comprehensive financial planning, you may invest all the money in the stock market or otherwise. But for a young investor in 20s, chances of them having more immediate liabilities is much lesser and most of them would be in a great position to invest in a higher generating returns products to beat inflation and also create wealth over a long term.
Align your financial goals to create ideal asset allocation:
Your asset allocation should be aligned with your different financial goals. You should maintain a separate allocation target for each of your financial goals. For example, you have more than 20/25 years to create a retirement corpus so you may want to have a more aggressive allocation towards retirement as compared to a more conservative plan for an immediate or short-term goal say buying a house or a car in the next three-five years. As a young person, you should invest 75-80% of your savings in good mutual fund schemes via SIPs & lump sum and do not let your gold investment exceed 10% of your overall portfolio. If buying a house to stay in is an immediate goal then most of your savings will go towards funding your EMIs, make sure not to stop or reduce your SIPs beyond a level, it is a must for creating wealth.
Source: DNA Money