Importance of Asset Allocation

Equitymaster talks about what it means by 'asset allocation' with regards to a stock portfolio and how you can draw up the ideal asset allocation plan.

In the past few years, the stock market has been on a roller coaster ride. Investors have seen the Sensex reach dizzying heights and then crash with equally dizzying speed. One moment the surge was the toast of the town. At the very next moment as the Sensex crashed, so did people's dreams; and investors were in a state of collective mourning.

Even as the markets today look promising, many investors are still confused. "How and where do I invest my money," is the question on everyone's mind.

While investors know that equities or stocks should form a key component of their investments, they still do not know how they should go about deciding which companies to invest in. So, they usually tend to rely on 'tips' or on their broker's or friends' advice. Then when an unforeseen situation like the Stock Market crash is witnessed, that is when the proverbial cookie crumbles.

In order to safeguard one's investment, it is essential to follow the principle of "asset allocation" while investing in equities.

So what exactly do we mean by 'asset allocation' with regards to a stock portfolio?

Simply put, asset allocation in equities is just a practical extension of the age-old adage - "Do not put all your eggs in one basket." It advocates the need to have a stock portfolio where your investments are distributed over not only different companies and sectors, but also cover different types of equity groups such as small caps, large caps and mid caps. The actual allocation should be a function of your investment objective and also your appetite for risk.

When you smartly allocate your 'equity money', the risks you take get distributed.

Suppose, for instance, there is a drought and as a result of which consumer demand in the country is expected to suffer a setback. Now, companies which are focused on selling their goods and services to the domestic market are likely to take a hit as their near term prospects no longer look great.

But on the other hand, a company that is selling software services in the global market will be relatively isolated from these developments. So, having both such companies in a portfolio has the impact of reducing the volatility in returns over time.

Thus having stocks across sectors is a step towards investing wisely. Holding stocks of companies with different market capitalization (like small caps, mid caps and large caps) is a step further in the same direction.

A small cap company like NIIT, with a market cap of Rs 10 billion, may promise greater rate of returns compared to say a large cap company like Infosys which has a market cap of Rs 1,400 billion. However, the security of having a blue chip company like Infosys in your portfolio cannot be matched by small caps.

This is of course a very simplistic example, and the following articles will discuss the pros and cons of companies with different market caps even further, but the core idea is to have a mix of companies in a portfolio.

Let's take another very well known example: During the late 1990s everyone was talking about and investing in what they called "Tech stocks" as technology was perceived to be a booming sector. Everyone wanted to position their portfolios and capitalize on what was then called the 'new economy'. And we know what happened soon after... tech stocks crashed. In fact hundreds of these tech wonders actually disappeared (mostly the smaller companies) leaving a big hole in investors' portfolios. A smart investor, who had a well diversified portfolio, though impacted, far outperformed 'tech' leveraged investors over the years that followed.

And at the end of the day, that's what matters the most - what you earn from your stock portfolio over the long-term. After all stocks are instruments that are best suited for generating long term wealth!

Why should it be done?

We need the returns on our investment for different reasons. Some invest in equities to secure their life after retirement. For others, equities are meant to be used for their child's marriage or education. For some others it may just mean funds for planning a world tour two years down the line while for some it may be a combination of all these goals.

As our needs differ, so does the time period needed to fulfill them. While planning for a world tour may be viewed as a short-term (2-5 yrs) objective, investments done for a child's education may be done keeping in mind a time period of 5 - 15 years. So based on the duration for which you require to keep your money invested in, you need to accordingly allocate your 'equity money'.

How do you draw the ideal asset allocation plan?

Each individual is different so an asset allocation plan will differ from person to person based on his or her personality traits, age, risk taking capacity and the ultimate investment objective in mind. One cannot take a 'one size fits all' approach.

Building a stock portfolio is a complex activity. In this guide we will focus on one very key aspect - how to allocate your portfolio between large cap, mid cap and small cap stocks. The following articles are aimed at giving you a deeper understanding of the various parameters influencing asset allocation in order to benefit the most from your investments.

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