Financial planning involves setting different financial goals, quantifying those goals, accounting for inflation, and having an investment plan to achieve those goals. A financial plan acts as a guide for your future and helps you control your income, expenses and savings.
The role of asset allocation
When you begin the financial planning process, you start with your goals in mind, then work backwards and develop a plan to achieve those goals. Investors should allocate their funds based on their risk appetite, goals and investment horizon. Helping you achieve this goal is a prudent asset allocation strategy. Asset allocation helps balance risk and growth while achieving long-term financial goals. It helps an investor leverage more than one asset class while ensuring concentration risk is at bay.
Each asset class behaves differently under different economic conditions. But each asset class also has a unique objective in the portfolio. For example, stocks provide the element of growth while debt investments would provide stability to your portfolio. Add to that a commodity like gold, they provide a hedge against inflation. Overall, a portfolio comprised of all of these asset classes will ensure an optimal balance between risk and return while aiming to secure optimal returns.
An important aspect to remember here is that asset allocation is not static in nature. As an investor goes through different phases of their life, their risk tolerance also changes and this will also be reflected in asset allocation. If one does not know how to go about it, then they can use the help of an asset allocation mutual fund. The other option is to consult a financial advisor who will help you develop your asset allocation strategy and guide you through it.
Sound financial planning and asset allocation involves an element of portfolio rebalancing as needed. For example: if the target asset allocation is 50% equity and 50% debt, a strong rally in the equity market may skew the allocation to 70% equity and 30% debt. This drastically changes the risk profile of the portfolio. Therefore, it becomes imperative to account for equity earnings and allocate more to debt so that the proportion is more or less maintained and therefore the risk profile is maintained at all times. But this activity involves tax implications. Because of all these complications, investors often tend to forgo rebalancing.
Another challenge to overcome comes in the form of emotions – greed and fear. In a raging stock market, investors forgo rebalancing in hopes of reaping higher profits. On the other hand, in the event of a market correction, investors fear that they will be reluctant to think more about potential losses. Therefore, human behavior tends to deter prudent asset allocation.
Asset Allocation Funds
To avoid these hassles, investors can consider investing through asset allocation systems. Here, based on his needs, an investor can choose a balanced advantage class fund in which the portfolio will have two asset classes – equity and debt or a multi-asset fund in which the portfolio will have three asset classes or more ; the most common being stocks, debt and gold.
In a balanced benefit scheme, the asset allocation between the two asset classes – equities and debt – is quite dynamic and changes depending on the prevailing market conditions. As a result, such a fund has the flexibility to better manage volatile market conditions by buying stocks when they are available at a relatively cheaper valuation and selling them back at a higher valuation when the market rises. Due to this arrangement, the returns generated tend to be much more stable than an equity fund. Additionally, the approach is emotion agnostic and this form of rebalancing is also tax efficient as the investor does not pay taxes when rebalancing in a fund.
Indeed, by investing in a dynamically managed asset allocation system, one can be assured that the fund manager will rely on market conditions to allocate assets between asset classes. Such an offer also provides a huge boost to broader financial planning.