Investing is an essential part of a financially secured future. Most of us work hard to earn money and save it. Therefore, when you invest your money it is important to take several aspects into consideration. Most investment advisors recommend that investors look at their financial goals, risk tolerance, and time horizon of investments in order to create an investment plan. They must also keep in mind the importance of asset allocation in investing.
What is Asset Allocation in Investing?
Once you are clear about your investment objectives, risk preference, and investment horizon, you need to start looking at the various asset types that you can invest in to achieve your goals. This is one of the most important aspects of successful investing since it determines how your money will work for you. Asset Allocation is the distribution of your funds across various asset classes like real estate, gold, debt, equity, cash, etc. It helps you adopt an investment strategy to balance your portfolio’s risk and reward ratio keeping your investment preferences in mind.
Importance of Asset Allocation in Investing
Here are some benefits offered by optimal asset allocation which make it important for successful investing:
While a good investment plan provides a sense of direction to investors, ad-hoc selection of asset classes makes it difficult for investors to determine if the selection of assets will be able to help them earn returns sufficient enough to achieve their financial goals – short-term and long-term. At times, investors can get either too aggressive or too conservative and fail to earn optimum returns on their investments. This is where optimum asset allocation can help them determine the returns that they can expect based on the risks taken by them.
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Let’s say that an investor invests in equities and earns handsome returns. Based on this experience, he might be predisposed toward investing in equities in the future. On the other hand, if he suffers losses, then he might become too conservative and stay away from equities and invest only in fixed-income instruments like bank deposits, etc.
While past experiences can be good teachers, without a proper asset allocation plan an investor might either be too conservative or aggressive with his investments. A well-thought over asset allocation of the portfolio can ensure that the investors take lesser risks on their investments and have more certainty about achieving their financial goals.
Aligning investments as per the time horizon
Apart from the risk associated with an investment, the investment horizon is critical for the achievement of the financial goals. The time horizon of investment also helps an investor determine the asset classes which should have dominance in his portfolio of investments. Let’s look at an example:
Investing in equities is considered to be high-risk, especially in the short-term and relatively lesser risky in the long-term. This is because, over an extended period of time, equity investments have a better opportunity to recover from the volatility of the stock markets. Without an optimum asset allocation plan, the investor might tend to prefer debt investments over equity for short-term horizons. However, if the investor has a long-term investment horizon, then the return offered by most debt investments might not be sufficient to achieve the long-term investment goals. Ensuring that he chooses the right mix of different asset classes based on the time horizon of investments can make achieving financial goals easier.
Another important aspect of successful investment is liquidity. Many investments have a lock-in period within which investors cannot redeem their investments. The lock-in periods can vary from a year up to 3 or 4 years. When an investor makes an investment, he must take liquidity requirements into his consideration. For example, if he invests in an investment instrument with a 3-year lock-in and needs money after one year, then it is a bad investment decision. Therefore, a prudent investment plan involves taking liquidity requirements into consideration and allocating assets accordingly.
Understand the Asset Classes
Whether you employ the services of an investment advisor or not, it is important to understand the way different asset classes can work towards your financial goals. For example, if you have a low-risk tolerance, then before you completely disregard investing in equities since they are considered high-risk investments, you must spend some time in trying to understand how equity investing works and if you can use the asset class to earn returns.
A good portfolio of investments, usually, has a healthy mix of different asset classes which work together to help realize the investment goals. Also, if you are aware of the role each asset class plays in your portfolio, then you will be able to initiate corrective action if one or more of them fail to perform as per your expectations. The age of the investor also plays an important part in determining the asset classes that should be a part of the portfolio. Take all aspects into consideration before finalizing asset allocation in your investment portfolio.
In a nutshell
Remember, asset allocation helps you in minimizing the risks of investment while helping you achieve an expected rate of return. Every investor has a unique requirement and needs a unique asset allocation plan. Therefore, refrain from following the best asset allocation suggestions from online resources or friends and spend some time understanding your financial requirements before investing. Each asset class will have some pros and cons – research well and try to invest in a basket of products which work in sync to help you achieve your financial goals.