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Overview | Knowing yourself | Asset Allocation and Diversification | Rebalancing and Monitoring


Stock Bonds

Once you have done self-assessment, the next step would be to identify in which asset classes you should invest in.

When you look at the investment landscape there are a lot of assets and as an investor you really don't know -

  1. which asset must form part of your investment plan and
  2. if it must, then how much of it should you own.

This is where asset allocation becomes important.

Asset allocation means distributing your money across various investment avenues or assets (such as equity, bonds and cash) so that the poor performance of any one avenue/asset does not jeopardise the entire investment plan. The goal is to help reduce risk and enhance returns and your money is poised to take advantage of the ‘booming’ sectors, while protecting you from heavy losses.

Asset allocation is the key to wealth creation.

So what can asset allocation offer investors?

The advantage of having different assets in the portfolio is that a decline in any one asset can be partially offset with the presence of other assets, which are not witnessing the same trend (in this case a decline).

Obviously being too heavily invested in any on asset class would set you up for a ride on the investment roller coaster. And there are very few investors who enjoy that trip. The reason why having more than one asset can work in your favour over the long-term is because different assets react differently to the same set of factors. For instance, inflation which can be a negative for stocks in the short-term, could actually lead to a rise in gold prices. So if your portfolio is well-diversified, then an unfavourable situation in a particular asset class will be combated by the other.

Allocate your assets

The percentage of your portfolio that you allocate to stocks, bonds, mutual funds or cash will depend upon your financial goals, investment time frame and tolerance for market risk as we have discussed earlier.

Generally, a larger portion of your portfolio should be dedicated to:

Stocks, if...

  • You have a relatively long investment time frame — 5 to 10 years or longer, and
  • You want the potential to make substantial returns on your investments to reach your goals, and
  • You have the risk tolerance to withstand significant market volatility.

Bonds, if...

  • Your goal is to preserve your assets.
  • You have a mid- to long-term investment timeframe.
  • You can withstand some fluctuation in asset values on the way to achieving your goals.
  • You need an income stream from your investments.

Cash equivalents, if...

  • You may need to access a significant portion of your money in the near term.
  •  You don’t mind a minimal return on your money.
  • You are risk averse.

Conservative - Click here to enlarge the image

Click to enlarge

Click here to enlarge the image

This chart shows how five asset mixes align with different approaches to investing, from relatively conservative to relatively aggressive.

Diversify within asset classes

The portfolio pyramid* is a way of looking at your portfolio to determine if it's truly diversified both across and within asset classes. As you can see below, the pyramid breaks down a portfolio into manageable layers, making it easy to uncover any unhealthy symptoms.

Stockbonds Manger

Once you have alloted your money to different asset classes for investment, it is important that you also diversify within each asset class. The next step would be to spread your money over various investment options within a particular asset class. The old adage holds true—don't put all your eggs in one basket.

Choose shares or equity mutual funds that represent a greater variety of industries and companies. For example, suppose you are an aggressive investor with total investments across asset classes totaling Rs 5 lacs and you decide to invest 70% of your portfolio in equities. Now the Rs 3.5 lacs that you are investing in equities should be divided among different segments of the equity market, ranging from large companies to small companies or domestic to international. And also in companies belonging to different industries like automotive, financial services, IT, etc.

An example of a diversified stock portfolio:

Diversification across industry

Diversification across market capitalisation

Diversification across market capitalisation Diversification across market capitalisation

The above portfolio constitutes of shares of various companies that belong to different industries and across market cap.

This example is for illustrative purposes only. The diversification of your own portfolio will depend on your financial goals, risk tolerance and time horizon.

Identify the industry of the shares you own, and be sure to review the holdings and investment objectives of your mutual funds. Investing your money in mutual funds of different mutual fund families may not actually provide adequate diversification as they may be invested in the same or similar securities. For example: If you purchased three stock mutual funds with growth as an objective, the funds are likely to be invested in the same companies.

Tip: Keep in mind, however, that all investments involve some risk. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Remember that diversification cannot eliminate the risk of fluctuating prices and uncertain returns.

*Portfolio pyramid taken from the article ‘The Portfolio Pyramid: How to Diversify Your Investments’ (2007) by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc.