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What is asset allocation and is it important?

Your money is too vital to be invested without a strategy. As you invest for different financial goals that have different time lines, you need to follow an investment approach that helps you realise your financial goal.

Asset allocation means dividing up your investments among the different asset classes in a way that you will be able to achieve (part of) your financial goals according to the risk that you are willing to take.

Broadly, there are three types of asset classes : equity (stocks), fixed income (deposits, bonds etc) and commodities (gold). The idea behind asset allocation is that these instruments are fundamentally different in the way they react to what happens in the economy and the markets: their characteristics can be seen as complementary up to a certain extent.

Often an investor gives a lot of importance to which companies or which mutual funds he should invest in. While this is important, it is more essential to first decide the mix of asset classes he should have. However, there is no one-size-fits-all perfect asset allocation model. What's good for you might be less so for someone else, as each person has his/her own goals, time horizon and risk preferences.

What is important with asset allocation is to rebalance the portfolio in order to maintain the desired allocation. That's because over time, an allocation will likely change. Imagine this simple example: If your assets are split equally between stocks and bonds, and over three years your bonds hold steady, but your stocks double in value, your allocation will no longer be 50-50. The allocation at the end of three year will be 33-67, with stocks making up much more of the overall portfolio. To bring your investment back to its original asset allocation you need to sell your equity holding and increase the holdings in bonds.

Typically it is a good practice to check once a year whether or not your portfolio should be rebalanced. This way not only will you be able to reset the allocation you started with, but also see if you need to make changes in your portfolio due to changing market circumstances or your changing risk tolerance.

KEY POINTS

  • Asset allocation contributes significantly to the performance of your portfolio in the longer term, not individual stock selection.
  • Asset allocation depends on factors unique to you
  • Rebalancing to maintain the desired allocation should not be forgotten.
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Mutual fund investments are subject to market risks, read all scheme related documents carefully.