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Why Is Asset Allocation Important and What Is It?

The idea of asset allocation often comes up while discussing personal finance. The act of distributing your assets across various asset classes, such as stocks, bonds, and cash, such that they are in line with your financial objectives and degrees of risk tolerance is known as asset allocation. Equities, fixed income assets, and cash are the three asset classes that are allocated the most often.

It is impossible to exaggerate the significance of asset allocation. Here are some justifications on why it matters.

Diversification: You may lower your risk exposure by distributing your assets across a variety of asset types. Stocks are an example of an asset class, and investing only in them makes you susceptible to changes in the market. However, by diversifying your holdings, you may be able to lessen the effect that any one asset class will have on your portfolio as a whole.

Risk management: By matching your assets to your level of risk tolerance, asset allocation may help you manage your risks. As an example, if your risk tolerance is low, you may choose to invest more of your portfolio to bonds or cash, which are often less volatile than stocks. However, if you have a high risk tolerance, you may choose to put more money to stocks, which have a history of providing better long-term returns at the expense of increased risk.

Goal Alignment: You may connect your investments with your financial objectives by considering asset allocation. You could choose to dedicate more money to cash or short-term bonds, which are less volatile and provide a more predictable return, if you have a short-term objective, like saving for a downpayment on a home. On the other hand, if you are saving for a long-term objective, like retirement, you may want to devote more money to equities since they often offer better long-term returns.

Rebalancing: Another aspect of asset allocation is regular portfolio rebalancing to keep it in line with your financial objectives and risk tolerance. For instance, you could wish to sell some stocks and reinvest the profits in bonds or cash to balance out your portfolio if equities have done well and now make up a bigger amount of it than you expected.

WORKINGS OF ASSET ALLOCATION

Consider that you wish to distribute your Rs 1 lakh investment portfolio across several asset types. An example of how you may split your portfolio is as follows:

Investing in stocks: 50% (Rs 50,000)

Investments in Fixed Income Securities: 40% (Rs. 40,000)

10% in cash (equal to Rs. 10,000).

Your 50% stock allocation is driven by your greater risk appetite and long-term financial objectives, while your 40% fixed income and 10% cash allocations are motivated by your need for some stability and liquidity in your portfolio.

Let's imagine that a year from now, thanks to the stock market's great performance, your equity allocation has increased to 55% of your portfolio, while your fixed income and cash allocations have decreased to 35% and 10%, respectively.

You can think about selling some of your equity holdings and using the money to acquire fixed income securities until your portfolio allocation is back to 50% equity, 40% fixed income, and 10% cash in order to restore balance. Rebalancing is the procedure that makes sure your portfolio remains in line with your financial objectives and risk tolerance over time.

It's also crucial to keep in mind that asset allocation and rebalancing tactics will change depending on a person's financial objectives, risk tolerance, and time horizon.

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