When you commence the process of financial planning you start off with your goals in mind. Then you work backwards and work out a plan to achieve these goals. Of course, you cannot achieve your long term financial goals by just saving in a bank savings account. The returns will just not be sufficient. What you need to do is allocate funds to risky investments and take calculated risks. That is the way to ensure that your principal earns returns and your returns also earn returns over a period of time.
So what exactly is the importance of asset allocation in financial planning? Are there are specific steps of asset allocation. Above all, what are the advantages and disadvantages of asset allocation and how does it fit into your overall financial plan. When it comes to financial planning, asset allocation has a very major role to play. Here is why..
So what exactly do we understand by asset allocation?
It is all about implementing an investment strategy that balances risk and returns. We know that all investing activity is about striking a balance between risk and returns. This balancing is done by adjusting the percentage of equity and debt as well as liquid assets in the portfolio. An allocation with a higher exposure to equity is a more aggressive strategy while an allocation with a higher exposure to debt is a conservative strategy. Look at the allocations below..
As can be seen from the above two pie charts, the aggressive portfolio has a much higher allocation to equity while the conservative portfolio has a much higher allocation to debt. Normally, an aggressive portfolio tends to yield much more compared to a defensive portfolio in terms of wealth creation over the longer period of time. However, the returns on an aggressive portfolio can be quite volatile over shorter time frames. That is why it makes sense to shift more towards debt when you have a very short term time frame or when your goal timelines are approaching or as your progress in age.
Importance of asset allocation in your financial plan
While asset allocation is a dynamic process and is subject to change, it helps to lay out a broad plan for achieving your long term goals. There are 5 key reasons why asset allocation is important to your financial plan…
It translates your risk appetite into a cogent and actionable number in the form of percentage allocation to various asset classes. As we have seen in the asset allocation chart previously, an aggressive allocation has a greater allocation to equities while a conservative allocation has a greater allocation to debt.
The asset allocation plan lays out how much risk you need to take based on how much risk you can afford to take. If you take more risk that you can afford to take then you are exposing your portfolio to unnecessary volatility and downside risk. At the same time, if you are taking less risk than what you can afford then you are making a sub-optimal allocation and that will result in lower than expected returns. This could have a larger implication for your long term financial plan.
The asset allocation defines a pathway along with your asset mix needs to move. For example, as you age your exposure to debt has to automatically increase. Similarly, as you approach key goal milestones, you need to shift a greater portion of your cashing allocation to debt. This will ensure that market volatility does not impact your. This kind of granular planning is only possible through asset allocation.
Asset allocation also helps you track the sensitivity of your portfolio and your investment plan to external stimuli. What happens if inflation goes up by 200 basis points or what happens if interest rates fall by 200 basis points? Additionally, what if the equity risk goes up due to volatility or gold suddenly becomes a more attractive asset from an investment perspective? How to make changes to the portfolio and the asset mix based on how these variables are moving? All these questions can only be answered by asset allocation.
Asset allocation over a longer time frame helps you to clearly define your cost of financial planning. When you plan your finances, there is a cost in terms of transaction costs, statutory costs and switching costs. All these can be clearly demarcated to judge the effectiveness of your financial plan in net effective terms.
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