Asset allocation is an integral part of an investment portfolio. It helps to diversify the investment of various asset class such as stock, bonds, debentures, real estate, cash, and cash equivalents. By diversifying the portfolio, one can mitigate the risk of the investment made.
Investors prefer to go for asset allocation as it helps to minimize risk and maximize the return on the portfolio. One cannot guarantee that is in which proportion they need to distribute various asset class which can maximize the return and minimizes the risk. Only a solid strategy requires the diversification which will help to optimize the investment made on the portfolio. Through asset allocation, we distribute what proportion of money goes to the various asset class.
There are various strategies which the investors make for investing in the portfolio. In most of the case, investors diversify their portfolio which is the mix of both risky and risk-free asset. Risky assets include investment in stocks and derivatives. The risk-free asset includes bonds, debentures, etc. Asset allocation is done also based on the risk appetite of the investors. It is a fact that the more you take the risk, the more you can expect a return and vice-versa.
While this is an overview of asset allocation there is a five-step process that follows the strategic asset allocation process:
Risk Assessment: The first and foremost step is to determine the risk tolerance level of an investor which is in a detailed manner with the risk tolerance questionnaire and by discussion between the investor and the entity constructing the portfolio.
Identifying the investment Horizon: This is the duration for which an investor wants to keep money in the portfolio or invest in the market. Investment horizon can help choose the long-term or short-term strategy to be used for the investor and accordingly choose the products with risk assessment.
Asset allocation based on broad asset classes: This comes in after the above two steps where allocation to the broad-based asset classes like cash, fixed income, and equities which is done based on the expected return on these asset classes.
Further breaking down asset classes: Dividing the asset classes into subcategories based on the market capitalization like Large Cap, Mid Cap, and Small Cap or by analytical groups or by their geographical divisions. The allocation is done based on percentages similar to the broad-based asset allocation.
Rebalancing and Monitoring: After a pre-determined period like monthly, quarterly or yearly a sort of review is done to make changes to the buy-hold strategy adopted. The changes are made by the entity which is managing the portfolio and to basically ensure that the allocation in broad asset classes is brought back to what it was initially.
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