Now, in this colum, we will discuss ways to build an investment portfolio that provides the best risk-adjusted inflation beating return. The most important ingredient here is getting the right “asset allocation”.

Your ideal asset allocation is the mix of investments, from most aggressive or high-risk to the safest or low-risk, that will earn the returns over time that you need. The mix includes equities, fixed income assets, gold, real estate and cash/money market assets. The percentage of your portfolio you devote to each of these asset classes depends on your time frame and your tolerance for risk.​

As the name implies, asset allocation refers to distributing your investable surplus across asset classes such as equity, debt, gold, real estate or even holding cash for that matter. So, by allocating assets, you are essentially adopting an investment strategy which can balance your portfolio’s risk and reward keeping in mind your risk profile, your financial goals, and your investment time horizon. 

The chart below illustrates an example of an optimal asset allocation.

What are the benefits of proper asset allocation?

1. Optimal Return – In the absence of proper asset allocation, a lot of us invest in an ad-hoc manner. This in turn makes it difficult to determine whether the return on investments is sufficient enough to achieve your short and long-term financial goals. Proper asset allocation will help you determine how much return you can expect on your investments on the basis of investment risks you are taking.

2. Risk Minimization – Proper asset allocation minimises risk on the investments and provides more certainty to achieving your financial goals. Based on your past experiences, you can either be very aggressive with particular asset classes or very conservative. However, a diligently followed asset allocation approach takes out this bias based on past experiences. 

3. Help investments align as per Time Horizon – Along with your risk profile (ability to take risk on investments portfolio), your time horizon is also a key factor to decide the asset allocation, while you endeavor to achieve your financial goals. Your time horizon will determine in which asset class you should invest a dominant portion of your investible surplus. 

Pro tip: Just remember, the longer your time horizon of your financial goal, the more you can tilt your asset allocation towards equity and less towards debt. 

Equities are considered very risky in the short term while less risky in the long term, as they will have more time to recoup from turbulent phase(s) of the equity markets. While debt is considered less risky, the returns clocked by this asset class are usually insufficient to beat inflation, and thus may not help you achieve your long term financial goals. Proper asset allocation will help you to determine the correct mix of equity, debt, gold, real estate and even cash based on your time horizon to achieve your financial goals.

4. Minimize Taxes – If you happen to be under the 30% tax bracket and invest all your savings in fixed deposit to keep your investments safe, then you are making a big mistake by paying huge amount in taxes, which otherwise could have been legitimately saved. Tax consequences are different for every individual and for every scenario so you should always view investment returns from the point of view of post-tax returns on investments rather than pre-tax returns as post-tax return is the return which you get in your hand. Proper asset allocation will not only help you to determine the right asset class, but also the right investment product which will help you to minimize taxes.

5. Adequate Liquidity – Liquidity is also one of the vital factors while making investment decision as some investments have a lock-in period and cannot be redeemed within that period. For example, if you are investing in a Public Provident Fund (PPF) account or Equity Linked Saving Scheme (ELSS) mutual fund and are in need of money in next 1 year, then they are not the right investments for you, no matter how good these investments are. Prudent asset allocation will make sure that you have sufficient liquidity to pay for your financial goals as and when required.

In conclusion

Defining an optimal asset allocation is not quite so easy, because you need to take into account a host of factors to reap the benefits of prudent asset allocation. However, once you have a prudent asset allocation ​in place, you can be rest assured that you will earn adequate return, minimize risk and taxes, have sufficient liquidity, and even achieve your financial goals over time.