Investors today have
many options where to invest their hard earned money but each option comes with
a risk-reward tradeoff associated to it. One may choose to invest in
instruments that have the potential to deliver high returns but on the flipside
these very instruments also carry the risk of suffering huge losses during a
rough patch, which may not be acceptable to the investor.
The biggest mistake that investors tend to make is to make investments in one
type of instrument only. Its like putting all eggs in one basket devoid of any
kind of diversification. This is a dangerous way to invest where one is putting
most of the capital at a risk of permanent loss.
The answer to this predicament is to find out one's attitude towards investing
or one's risk profile and then arrive at a suitable asset allocation, where one
could put money into different investment options. By doing so, risk is spread
out and quite mitigated. It means to diversify the investment allocation in a
manner which quite ensures that no one type of investment would determine the
entire success or failure of achieving one's financial goals or objectives.
Understanding one's risk profile or attitude towards investing is the first
step towards investing the right way.
Asset
allocation is the tool which is used for building a diversified investment
portfolio. It determines the extent of one's portfolio that would be invested
in different asset classes, such as stocks, bonds, cash, etc.
One asset allocation
strategy does not fit all, normally the younger one is the higher is the
appetite for risk and the older one grows risk appetite reduces. Hence at a
younger age one is more inclined towards wealth creation and so prefers to see
the portfolio grow. As one moves closer towards retirement the preference
gradually shifts towards protecting the wealth created and thus a preservation
approach to investments is adopted.
Asset allocation used for building or redesigning the investment portfolio
depends on the profile of the investor amongst other things, which can range
from being defensive to aggressive as he moves from the accumulation to the
spending phase of his lifecycle.
Studies have shown that asset allocation determines more than 90% of portfolio
performance. *
* From the
study on the importance of asset allocation by Brinson Hood and Beebower.
Determinants of Portfolio Performance, Financial Analysts Journal, 1991.
Why Invest?
Risk
Mitigation
