What is Asset Allocation – How and Why You Should Do it

It is said that there is no free lunch in finance. However, asset allocation is one way where you can reduce your risk and improve returns. So let us go ahead with the first principles and understand what an asset is.

An asset is typically a resource that can generate cashflows when sold. There are many types of Assets but the main ones are equity, fixed income, real estate, cash, gold, PE, etc. Other exotic ones are stamps, art, and rare items like antiques, wine bottles, etc. Your wealth will be typically composed of these assets.

Asset allocation is how you should structure the combination. For example, many people consider a mix of 60-40 between fixed income and stocks to be perfect. So how does asset allocation help and why should you have a mix?

Let’s say you had 100% equity exposure and the stock market crashed by 90%, you would become a pauper overnight. But if you had 60% in fixed income like fixed deposits then your wealth would have gone down by only ~30% instead of 90%.

The magic of asset allocation is due to a low or negative correlation between assets. What this means is that the extent of increase/ decrease in one asset is not the same as the other. For example, generally when prices of bonds increase due to a recession, then equities decrease and vice-versa. Gold is a great asset diversifier as it is a very safe asset in times of war, hyperinflation, etc. For instance, for people in Venezuela, Zimbabwe, and Ukraine gold would preserve its value when the currency crashes, given the current scenario in these places. Lebanon recently devalued its currency by ~90%, killing the value of cash, equity, bonds, etc. Similarly, real estate also holds value in times of inflation and my advice is to buy at least one property even though fin-influencers say only keep money in equity/ bonds.

Asset allocation should also change with your age. You can take more risks when you are young so have more exposure to equity and when you get old have more exposure to Fixed Income. One rule of thumb on equity allocation is (100 – your age) i.e. if your age is 25, then 75% in equity allocation, though it also depends a lot on the current valuations.

Asset Allocation is a complex topic and it is best to take the help of a financial advisor. Many people I know invest too much in fixed deposits or real estate. It is tax-inefficient and concentrated. Also going overboard on equity/ SIPs is stupid. Asset allocation is something everybody should know and understand as it will affect your and your family’s wealth.