Asset Allocation – Optimising Portfolio Returns

Your investment portfolio serves a two-fold purpose. One is to grow your wealth so that you can achieve your financial goals and the second is to preserve your wealth so that it is available to you in case of emergencies and can be used by your future generations. In order to accomplish the above, you need to construct a portfolio that can generate the desired returns within the risk parameters specified by you. An asset allocation strategy can help you optimise the risk adjusted returns of your portfolio and in turn assist you in reaching your goals.

What is Asset Allocation?

It is an investment strategy that aims to create the optimal balance between risk and reward by apportioning a portfolio's assets across multiple asset classes. The basic principle behind asset allocation is to invest in multiple asset classes that respond differently to similar market conditions. Historically, it has been observed that the returns from the major asset classes have exhibited little to negative correlation, implying that they respond differently to the same developments. This means that while a certain development could have a negative impact on a portion of your portfolio, the same news could have no impact on another portion of your portfolio. This ensures that the entire portfolio is not impacted from a big event or development. An optimal asset allocation strategy can help you minimise portfolio risk while maximising returns. In short, asset allocation helps achieve portfolio diversification and insulates the portfolio from extreme movements.

Optimising Your Asset Allocation

The asset allocation decision is largely influenced by three main factors. These include:

• Return Requirements

There are broadly four major asset categories viz. fixed income, equity, real estate and cash. Each asset class lies at some point along the risk/return spectrum and has unique capabilities in terms of generating returns. Additionally, the performance of each asset class is influenced by a host of factors, some of which might be common across asset classes and some of which might be singularly unique. However, it is important to point out that it is not sufficient to just invest across these asset classes to achieve optimal diversification. Even within each asset class, there are investment products that exhibit varying levels of risk and can consequently, impact the overall risk profile and return potential of the portfolio. For example: An equity investment in general would be categorised as a risky investment. However, within equities, different categories carry different levels of risk. In some instances, certain categories might be less risky than a fixed income product. In such a case, one has to be judicious about their asset allocation strategy and ensure that the risk is not concentrated.

“Don’t put all your eggs in one basket” is a truism that is relevant even today in the investment world. Seek to build a diversified portfolio that is capable of weathering external volatility without compromising on returns.