Introduction
There is an old age idiom “One shall never put all his eggs in one basket”. This perfectly makes sense when it comes to investing and financial planning. If you are investing your money, it’s necessary that you don’t put all your money in a single asset class.
Instead, you can spread your investment in different asset classes depending on your investment goals and risk appetite. In addition to investing as per asset allocation, one can further diversify the investment in each asset class.
In this article, we will understand what asset allocation is and why one needs to have a diversified asset allocation
What is Asset Allocation?
When an investor divides his portfolio into different asset classes like equity, fixed income, cash, etc then it is defined as asset allocation. The percentage of investment in each asset class depends on various factors like risk appetite, age, investment goals, etc. of the investor.
What is meant by Diversified Asset Allocation?
Asset allocation does reduce the risk but still, the risk persists. Suppose you have invested 50% of your investments in stocks. You have just invested in a single stock and if this stock doesn’t perform well then you may face loss even after asset allocation.
To reduce this risk, there can be diversification in asset allocation. This means the investment in each asset class shall be further divided into different assets of each asset class. Instead of investing in one stock, you shall invest in different stocks of different companies and sectors.
If you have invested in cash equivalents then invest in 2-3 cash equivalents like treasury bills, bank deposit certificates, etc. This is defined as diversified asset allocation.
Why is Diversified Asset Allocation Required?
Now that you know the meaning of diversified asset allocation, let’s understand why it is needed.
- Reduce Risk
Diversification in asset allocation helps you reduce the risk. This is because one investment in an asset class may not perform well but not all investments will go down. The loss in one asset will be recovered by another sub-asset.
Suppose you have invested 50% of your portfolio money in stocks. You have invested in an Airline Company as well as a Bus Travels Company. Now if the price of an airline stock goes down due to some change in air transport regulation, then the bus travel stock will increase as people will prefer the bus to the airline. Thus your loss due to airline stock fall is compensated by bus travel stock.
- Higher Gains
By diversifying your assets, you are increasing the chances of earning higher returns on your investment. This is possible because if you have diversified your portfolio among various assets, your odds of making a loss reduce. One investment may fail in an asset class. But not all investments in an asset class will fail. As different investments respond to markets differently.
- Fulfilling Goals
Diversification in asset classes helps you successfully achieve your desired goals. You need to understand that different asset classes respond to different market conditions differently. So if stocks don’t perform, then bonds may perform. Or if one company doesn’t perform, another company in your portfolio may perform. Thereby your overall goals are not affected.
Conclusion
In order to achieve higher gains and reduce the risk of your investments it’s advisable to have diversified asset allocation. And with the passage of time do take care to rebalance the portfolio as per the requirement.
