Asset allocation is the most frequently used yet the most commonly misunderstood term in personal finance. So, what exactly does asset allocation mean? Essentially asset allocation is an investment strategy. Asset allocation has 3 steps. Firstly, you assess the returns and risks of each investment option available like equity, debt, hybrids, gold etc. Secondly, you evaluate the relevance of each of these asset classes depending on your specific return requirements, risk appetite, tax status and liquidity needs. Lastly, you actually decide on the apportionment to various asset classes. That is what asset allocation is all about.

Finer points in the process of asset allocation..
  • Your asset universe must be broad and also flexible to accommodate new investment ideas that may come up. For example, equity, debt and gold are the traditionally time-tested investment avenues. But newer products with greater degree of customization are coming up. For example alternatives, structured products and hybrids are great ideas to make your financial plan more tuned. Then, there are products like Bitcoins that did not exist few years ago, but is a big asset class by itself and could get much bigger. Your asset universe must be open to changes.
  • How many assets do you want to spread yourself across? The thumb rule is that your spread should be dependent on the corpus that you are targeting. With a small corpus it is best to stick to just debt and equity. That will be a good balance between wealth creation and long term stability. Most of the other asset classes will begin to make sense if your corpus is much bigger.
  • Ensure that your asset allocation is well diversified in the real sense of the term. If you have 4 asset classes and all are going to react negatively to a hike in the US Fed rates, then your portfolio value could be in trouble next year when the Fed could hike rates as much as 4 times. Your diversification should be across asset classes and theme sensitivities.
  • Don 't forget to seek expert help in the asset allocation process. There will be algos and there will be automated robo advisories to help you in the asset allocation process. At the end of the day, you are talking about allocating for your long term future. Therefore it always makes a lot more sense to get an expert to advise you and assist you in the process of asset allocation.
Different strategies of asset allocation..
There are 5 broad strategies that can be followed with respect to asset allocation. Each has its own merits and demerits as we shall see below..

  1. Strategic asset allocation is based on return expectations. For example, if your return expectation is 12 % per annum, then you will decide your mix based on the historical returns earned by equity and debt. This needs to be constantly tweaked but expected returns will be the driving factor.
  2. Constant-Weight asset allocation focuses on maintaining a pre-determined weight to equity, debt and hybrids based on risk perception. Each asset class is given a leeway of around 5 % and once that is breached then the asset allocation is brought down to the original level. The advantage is that it builds a discipline of profit booking and will also enable your portfolio to stay liquid when asset prices are attractive.
  3. Tactical asset allocation is more active compared to a constant weight approach. In tactical asset allocation, you maintain a broad allocation to various asset classes. However, you have the flexibility to sharply increase the allocation based on your view. For example, if you expect interest rates to go down then you may temporarily increase your exposure to long term debt. Same could be the case when you find gold a good bet in times of geopolitical uncertainty.
  4. Dynamic asset allocation is a more aggressive form of tactical asset allocation. The revision of asset mix based on your asset class view is more frequent and more aggressive. However, in the case of dynamic allocation we need to remember that too much churning of the portfolio also entails a higher cost in terms of transactions costs, statutory costs and capital gains tax. All these will eventually impact the portfolio returns.
  5. Insured-asset allocation is a slightly different strategy used normally by active asset allocators. There is a risk that in the case of active allocations, your portfolio value could deplete. Under the Insured allocation approach, you will not permit the value of the portfolio to fall below the base value. In that case, the entire corpus will be invested in risk-free assets.
Mutual funds as an asset allocation technique..
If you think that asset allocation appears to be complex, then mutual funds could actually offer you the answer. You have a really wide spread. Within the gamut of equity funds you have diversified funds, sectoral funds, thematic funds and ELSS funds. Within the gamut of debt funds you have liquid funds, liquid-plus funds, MIPs, corporate debt funds, G-Sec funds and income funds. Within hybrid funds you have balanced funds, MIPs and dynamic allocation funds. To add it, if you want to get passive in your allocation then you have index funds, index ETFs, gold ETFs etc. In a nutshell, MFs can offer you the entire process of asset allocation on a platter. The choice is entirely yours!