Asset allocation refers to dividing your investments across various asset categories to maintain the desired balance between returns and risk. Often, while investing in mutual funds, investors focus on choosing funds within a category, missing out on the bigger picture, i.e., broader allocation of funds among different assets such as equity, debt, and gold, among others. Asset allocation involves deciding on an optimal mix of mutual fund schemes to achieve diversification and manage risk. This reduces your exposure to a single asset class and shields you from extreme market movements.
Asset classes in mutual funds
Mutual funds invest in a variety of asset classes such as equities, debt, gold, among others. There are funds that invest the entire amount in a single asset class, such as an equity mutual fund, and also those that invest in multiple asset classes (such as hybrid funds – which invest in a combination of equities, debt, and money market instruments). Further, there are international or offshore funds that help you diversify geographically by investing in stocks/themes of other countries and regions. Even within equity funds, there are large cap, mid cap, and small cap funds, and there are multi-cap funds that invest in a mix of all three.
The risk-return trade-off
Understandably, selecting the right mutual funds can be overwhelming given the options available. However, you can simplify this process by deciding on your asset allocation first. There is no ideal asset allocation that applies to all investors. Every individual has a unique, optimal asset allocation based on risk preferences, expected return, and the extent of diversification desired.
The aim of allocating your assets is to meet your expected returns while minimizing risk. For this, you would need to understand the risk-return characteristics of various asset classes. For example, equities have potential for high returns over a long period of time but also come with high risk. On the other hand, money market instruments such as T-bills and government securities have low risk but the expected return in this case is also low. This is referred to as the risk-return trade-off. Thus, your objective behind asset allocation is to get the optimal risk-return balance by investing varying proportions in funds of different asset classes.
Let us consider the three most common model portfolios:
- A conservative portfolio will allocate a larger proportion of investments to low-risk mutual funds such as debt funds to preserve capital.
- A moderate portfolio aims to preserve capital, and also take some risk to match inflation. Such portfolios will have a slightly larger proportion of equities compared to conservative portfolios.
- Finally, an aggressive portfolio allocates an even larger proportion to high-risk assets such as equity mutual funds to achieve capital growth.
Deciding the right asset allocation for you
When deciding your optimal asset allocation, there are several parameters you would need to consider such as financial goal, risk appetite and investment horizon.
First, identify the financial goal. If it is a short-term goal, then your asset allocation to reach that goal will have to be conservative. For long-term, you can have aggressive portfolio and for medium-term it could be a moderate portfolio. In general, the further away you are from achieving your goal, the more risk you can take because then you have time on your side.
For instance, if you’re 30 and plan to invest for 25 years for a retirement fund to be ready at the age of 55, then in the initial 10-15yr period your portfolio could take an aggressive stance. But as you get closer to retirement age of 55, your portfolio should become less risky.
While constructing a portfolio and choosing mutual fund schemes, it is important to check risk-related information via the riskometer, and also asset allocation within schemes to ensure that the scheme is aligned with your desired asset allocation.
Not a one-time decision
Asset allocation is not a one-time decision or activity. It is dynamic and changes as per the goal, time horizon and risk appetite. Ensure that you revisit and review your portfolio periodically and check if it is en route to helping you achieve your goals. It is also advisable to consult a financial advisor prior to taking a decision.