Investment is spread across equity and debt for balance and meeting both long-term and short-term goals.

What is asset allocation

Everybody knows what an asset is; it is something with an economic value, such as a house, car, investments, artwork, etc., that has the potential to generate cash flows.

But when you enter the world of investing, the word assumes a different dimension and is spoken along with other words such as asset class, asset allocation and diversification.

What do these mean exactly?

Financial assets

In investing, when we talk of assets, we refer to financial assets, such as the common stock or equity, and not of physical assets like a house, also known as real assets.

Financial assets derive their worth from a contractual right or ownership claim, and unlike real assets, these can be easily converted into cash. Because of this liquidity, they are also called liquid assets.

Related: Multi-Asset Allocation: Choosing Between Balanced Advantage Funds And Multi-Asset Allocation Funds

Unlike real or tangible assets, you cannot see or touch a stock, but they represent value to you.

In other words, a stock is a paper asset.

Other examples of financial assets are cash, bonds, mutual funds, bank deposits, commercial deposits, treasury bills, etc.

Asset class

Any financial asset that can be traded is called a security. Typically, securities fall into three categories:

  • Equity securities, which include stocks;
  • Debt securities, which include bonds and banknotes;
  • Derivatives, which include options and futures

A collection of securities exhibiting comparable traits and going through similar market fluctuations is called an asset class.

Securities of one asset class are generally bound by similar legalities and also face similar risk factors, tax norms, return rates, liquidity, tenures and market volatility.

The different asset classes are listed below:

  • Fixed income;
  • Equity;
  • Real estate;
  • Commodities;
  • Cash and cash equivalents;
  • Derivatives;
  • Alternative investments (like hedge funds, bitcoin, artwork etc.)

Related: How Is Asset Allocation Linked To Retirement Planning?

Asset allocation

Investors place different financial instruments in different asset classes so as to diversify their portfolios and maximise returns. This is called asset allocation.

When allocating their investments, investors usually spread them across equity and debt, the two predominant asset classes, and this is done because of two reasons:

  • First, this ensures the portfolio is 'balanced' at all times, as the different asset classes are usually not correlated, and when one goes down, the other holds up;
  • Second, this addresses the investor’s long-term needs (via growth assets like equity) as well as short-term needs (via income assets like debt).

In the process, the investor can take market fluctuations head-on: by moving money out of growth assets systematically when markets are rising and bringing it back in when they are falling.

Point to note: Asset allocation is not diversification; it is optimum exposure to non-correlated asset classes, while diversification is adequate exposure within an asset class.

Related: Why Asset Allocation Should Be The Core Of Every Investment Portfolio?

Effective asset allocation 

Different asset classes have different risk-return traits, and so, to be effective, the allocation must keep in mind financial goals, time horizons and risk profile.

Markets do not follow a set pattern, which means allocations can and should swing according to market movements.

Alongside, the portfolio should be periodically reviewed, ideally once in six to twelve months, and, if needed, be 're-balanced' to ensure unnecessary risk is not being taken to achieve one’s goals.