Everyone wants to create wealth and lead a comfortable life. Read on to find out , one of the secret recipes that can help your chances of getting more out of your investments. When you set out to invest there is a lot of choice available to invest in stocks, funds, bonds, gold, banks deposits and other financial instruments. Each of these choices is associated with a varying degree of risk. For instance, investments in stocks are risky in the short term compared to investing in say a bank deposit. The concept of asset allocation comes to your help in how much of which investment class do you commit to. Asset allocation is like a road map, which involves deciding how to allocate your investments among assets like stocks, bonds and cash equivalents such as money market funds, so that your investments are well spread out. The process of determining the right mix is personal, because the asset allocation that works best for you at any given point in your life will depend largely on the stage of life you are in, your goals including time horizon and the appetite of risk. Basically, you try and pick a mix of assets that has the highest probability of meeting your goal at a level of risk you can live with. In fact, determining an asset allocation suitable to you is more important than the individual investments you make. It may be a good idea to consider asking a financial advisor to help you determine your initial asset allocation and suggest adjustments for the future. You could also use online resources, which can guide you towards an asset allocation profile suited to your needs.
Remember, asset allocation is not a onetime process because it is dynamic process which should be maintained periodically.
The next step is diversification, which is many times used interchangeably with asset allocation, but is not the same. Diversification is a strategy that can be summed up by the timeless adage, “don’t put all your eggs in one basket.” The strategy involves spreading your money among various investments knowing that when one investment loses money, the other investments may more than make up for those losses. You could use asset allocation as a way to diversify your investments among asset categories.
Your portfolio will be diversified if you spread the money in your portfolio among different types of investments. Diversification can be better understood when you look further into an asset class. For instance, when investing in equities, diversification is possible across sectors and capitalisation and in case of debt instruments it could be based on tenure of the instruments. Remember, diversification is not about the number of stocks you invest in; it is about the wide spread businesses that you put your money into. This is where the convenience of investing through equity mutual funds comes in.
Having understood asset allocation and diversification, we come to the more important aspect – rebalancing, because allocation and diversification is not a one time action. Asset rebalancing means investing with a target in mind, in terms of how much of your investments should be in debt and how much in equity (say 30% in debt and 70% in equity). Since the two won’t rise in tandem, rebalancing them involves periodically shifting money from one to the other in order to stay on target. Rebalancing also keeps your portfolio consistent with your risk profile.
Remember, asset allocation is not a one time process because it is dynamic process which should be maintained periodically, because market movements can dramatically alter your asset allocation over time. For instance, a retiree who relies on his portfolio for income will be taking a risk if he stays invested with 90 per cent of the portfolio in equity just the way a 25-year-old who won’t retire for at least the next 30 years shouldn’t be invested in 90 per cent debt. What’s important is that you periodically check your portfolio to see if rebalancing is necessary.
Asset rebalancing is the most ignored of investment ideas, which is quite easy to implement. Rebalancing establishes good investing habits, even though it may seem wrong to sell an asset that is performing well, but that is exactly what you should do, as rebalancing forces you to buy low and sell high. Mutual fund investors, benefit from asset rebalancing as fund managers routinely exercise portfolio rebalancing based on several factors.
This move is also more tax efficient, compared to individuals setting about rebalancing on their own. If you are investing in equity mutual funds, this part of the process is taken care by the fund manager and you just need to monitor your overall portfolio in terms of investments in equity schemes and debt schemes.
And, if you are doubting whether asset allocation, diversification and rebalance actually works – rest assured there are numerous studies that have tested the authenticity of this principle in reducing overall portfolio volatility and improving your chances to earn stable returns over time and create wealth. Following this principle checks your emotions and also the temptation to time the market. The takeaway for you is that asset allocation helps you stay in control of your financial plan, tailoring your investments to fit your goals and tolerance for risk.
Numerous studies have shown maintaining asset allocation helps reduce overall portfolio volatility and improves your chances of wealth creation.
Portfolio diversification may reduce the amount of volatility you experience by simultaneously spreading market risk across many different asset classes.
By investing in several asset classes, you may improve your chances of participating in market gains and lessen the impact of poor-performing asset categories on your overall portfolio returns.
A well-allocated and diversified portfolio does away with the need to regularly adjust investment positions to chase market trends, and can save.
It’s a good idea to review your portfolio at least once a year to ensure that your asset allocation continues to be appropriate for your time horizon.
During periods of increased volatility, whether the market is going up or down. But take care not to react to every market cycle.
Rebalance whenever your allocation reaches a threshold that you are not comfortable with to bring in the balance.