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Asset Allocation

The basic principle and foundation of a portfolio is Asset Allocation.

While we were children, we were told ‘NEVER put all your eggs in one basket’. This age old grandmother advise is rock solid true today and forms the foundation of our investments & portfolios.

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Let us take a real life example: Smart street vendors sell unrelated products - such as say umbrellas and sunglasses? Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never - and that's the point. Street vendors know that when it's raining, it's easier to sell umbrellas but harder to sell sunglasses and when it's sunny, the reverse is true. By selling both items- in other words, by diversifying the product line - the vendor can reduce the risk of losing money on any given day.

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The basic principle of Asset Allocation is Diversification.

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Asset Allocation is a planning tool that allows the investor to structure his or her investment portfolios in a manner most likely to accomplish the goals established for each portfolio and for the investment program as a whole. Asset allocation is the process of planning how the portfolio is to be divided between the broad classes of investment.

Asset allocation involves dividing an investment portfolio among different asset categories, such as equity, mutual funds, deposits, bonds, gold, currency, cash, real estate and many other assets. The asset allocation that works best for you at any given point in your life may differ at a different point in life. Say the optimal asset allocation suitable for you when you are 30 years old will differ from the asset allocation when you are 60 year old.

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Asset allocation thus needs to be dynamic & will differ from individual to individual & from time to time, during the life time of the individual.

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Most financial experts & advisors believe that determining your asset allocation is the most important decision that you'll make with respect to your investments - it's even more important than the individual investments you buy. With that in mind, you may want to consider asking a financial professional to help you determine your initial asset allocation and suggest adjustments for the future.

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Asset allocation is critical to your portfolio, take professional help.

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Establishing an appropriate asset mix is a dynamic process and it plays a key role in determining your portfolio's overall risk and return. A good asset allocation will greatly increase your chances of getting optimal returns & of fighting the ups and downs of the market, because the down in one investment will be compensated by an up in another investment. A guiding principle of asset allocation is that a portfolio diversified among asset classes will never match the performance of the best asset class each year but it will also never equal the worst.

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Below is an actual chart of stocks and bonds. One can see from this example that if they decided to simply put all of their funds solely in stocks, they would be seeing a -15% decline in their funds. However if they diversified into other asset classes such as bonds, they would have been able to offset their losses with the gains that were seen in the bond market. However, the viva-versa can also be true where the bond markets were giving negative returns & the equity markets would handsomely reward the investor off-setting the losses in the bind investments. Hence in an asset mix the co-relation (negative & positive) between various asset classes will reduce the volatility & risk of the portfolio and provide optimal returns.

The example above shows an investor who is invested in stocks, bonds, and is holding a percentage of cash. However his or her bond allocation has an asset allocation plan of its own, which is split into corporate bonds and municipal bonds. This is an indicative asset allocation.

To observe the relationship of asset classes and their respective risk/reward levels, they can be plotted and surveyed in a chart like the one below.

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The goal of asset allocation is to maximize returns at a prudent level of risk or to minimize the risk involved in achieving a certain return. The process of determining the appropriate asset allocation involves an analysis not only of available investment asset classes but also of the investor’s personal objectives, time horizons, risk profile & many other factors.

Generally, the younger the investor the more aggressive investing strategies he can undertake since he has enough time to beat the ups and downs of the market. The closer the investor gets to retirement, the more conservative his investing strategy should get because he has less time to fix the potential losses. Additionally, an early start in investing greatly increases you chances of achieving your investment goals.

Cap Gain Pie Chart   

Hence a typical 35 year old can have an asset allocation as follows:

Asset Amount % of Total

Home : 55 laks 55%

Debt : 15 laks 15%

Equity/Bullion : 30 laks 30%

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However a 65 year old retired individual’s asset allocation will be:

Asset Amount % of Total

Home : 55 laks 55%

Debt : 40 laks 40%

Equity/Bullion : 10 laks 10%

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These asset allocations are just indicative of the change in asset allocation with age and the change in risk profile.

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I always ask investors one basic question which you should ask yourself before taking investment decisions:

How much time do you spend in a year to earn money?

How many hours a year do you spend in a year to manage this money?

With professional help it takes just about 2 hours a quarter which is 8 hours a year to effectively & efficiently manage a passive portfolio. Hence before plugging-in investments please check whether the investment suits your asset allocation & make asset allocation the blue print & foundation for managing your assets & making investments.

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