What is the importance of asset allocation at the individual portfolio level? Why should an investor worry about the same? Read my article in Gujarati Mid-day here.

You may read the English translation here:

Asset allocation 3

In the last two articles, we talked about asset allocation that happens within the mutual fund scheme. However, the chief requirement of the asset allocation is at the level of the investor. This is done in line with the investor’s unique situation and the risk profile. This would include three important aspects viz. the need, ability and willingness to take investment risks.

Once these three are understood, the investor’s portfolio can be structured through proper allocation of money across various asset categories. As we know, each asset category exhibits a different risk-return characteristic and hence the allocation to each has to be in line with the same. If the return requirement is high, one must allocate more money to the assets that have potential for delivering better returns, but these assets also carry higher risk. However, if one wants to reduce the risk, the allocation must be increased in favour of such assets that carry low risk, but also carry potential for lower returns.

Over a period of time, different assets would generate different returns, due to which the percentage allocation between different assets would change from original. This means that the changed allocation may impact the risk-return profile of the portfolio – either the portfolio would have higher risk than what the investor could handle, or the potential to generate returns would suffer. With this in mind, it is important to rebalance the portfolio at the desired asset allocation levels.

The rebalancing of the portfolio would mean that one is automatically selling the asset that has appreciated more and buying one that has not – in other terms, one is selling high and buying low. Even a small and ignorant investor can do this.

It is also important to understand the three basic assumptions behind this concept:

1. The asset categories that one invests in are likely to see price appreciation in the future
2. The future price appreciation would not be linear and there would be periods of high returns and low returns, and sometimes negative returns
3. Different asset categories would follow different paths in the future, which means while something is going up, something else may not

With these three assumptions, it is easy to see the benefit. With all the investments expected to move up over the long term, one would stay invested in those. However, with short term volatility, rebalancing would be immensely helpful.