Asset allocation is the best strategy

Structure your portfolio wisely for good returns.

For most of us,investing is simply about picking stocks that are expected to yield high returns in the future or parking our hard-earned money in safe instruments e.g. a bank deposit that offers a fixed rate of interest. Well,not exactly. In todays world wherein a multitude of global and domestic factors influence the state of our finances,investing requires a far more calculated approach beginning with the fundamental principle: Asset Allocation.

Asset allocation is the relative percentage of different asset classes (group of similar investments) in your portfolio which determines how much returns potential/ risk component your portfolio has.

It ensures that your investment portfolio comprises several mutually exclusive asset classes instead of a concentrated pie of similar and therefore highly correlated instruments. This correlation is the very reason why you should pursue an asset allocation strategy while crafting your investment portfolio.

Story continues below this ad

To put things in perspective,asset allocation pursues reduction in portfolio risks without substantially affecting overall returns or enhancing returns without substantially adding to those risks.

Lets look at an example to understand this more clearly. Consider a portfolio investing in stocks and commodities. This portfolio is likely to experience less volatility than a portfolio that comprises only stocks,without compromising on the level of returns. As is evident from the chart,with an asset allocation mix of 70 per cent investments in stocks (BSE Sensex) and 30 per cent in commodities,one can achieve the desired trade-off between optimal returns and investment risk.

Structuring ones portfolio begins with a simple process called Know Thy Self or an understanding of ones level of expectations in terms of return on investment as well as gauging ones ability to tolerate loss of capital.

Needless to say,both the factors go hand in hand i.e. if one expects high returns from an investment,s/he should be willing to accept higher risk if the chosen investment vehicle fails to perform. The graph appended below compares the risk and potential return of some of the popular asset classes.

Story continues below this ad

Once the returns expectation and the underlying risk has been gauged,one needs to arrive at the point of balance. After this,adding the right asset classes to the portfolio is a relatively easy task.

Having developed your portfolio with the correct asset allocation mix,you need to regularly review and rebalance it. This is because,over a period of time,different asset classes generate varying returns which automatically changes the structure of the portfolio. One may be required to sell certain asset classes that have risen in value,thereby adding to ones investment gains and also to maintain the original level of asset allocation.

On completion of a desired financial goal or if one wishes to change ones financial goal mid-way,the exercise must be revisited from the beginning.

In sum,as asset classes evolve and investing assumes complex proportions it must be ensured that ones investment portfolio is based on a unique asset allocation matrix that truly takes care of the returns expectation as well as risk appetite.

Author is the CEO,Mirae Asset Global Investments (India)