Asset allocation is a method that determines how you divide your portfolio among different investments e.g equities, bonds, cash etc. Each of the asset class has a different characteristic. Stocks have the potential to provide long term capital appreciation, while bonds and debt instruments provide regular return. And cash, of course is the king with the highest order of liquidity. Asset allocation suggests apportionment of your portfolio into different investments in a manner that maximises return while minimising risk.

Asset allocation is based on certain dimensions that, when combined, tend to control the volatility while achieving targeted returns that beatinflation. The goal is diversification, first among major asset classes (stocks, bonds, cash) and then within segments of those markets. The advantage of asset allocation lies in achieving superior returns when markets are down while minimising the exposure of portfolio to volatility. While considering fund investing, it is imperative to follow a reasoned and cohesive strategy rather that buying fund willy-nilly. The right way is to identify your goal or what you are trying to accomplish. How long can you wait? How much returns do you expect and how much risk are you willing to take? This will determine how much you should be willing to put in each asset class and the quantum of volatility you can stand in a fund.

Investment Objective

The fundamental factor that drives the asset mix is the goal of the investor or the purpose of an investment. The objective may be anything - right from aggressive capital growth to conservative capital preservation. The choice of your assets will be strictly governedby your objective. For example, if you were investing for retirement your main investment goal would be to amass sufficient funds to maintain your standard of living during your retirement years, i.e. a growth objective.

Risk Tolerance

Choosing the mix of financial assets that is right for you depends on their expected rates of return and on your need, ability and willingness to tolerate risk. Individuals may have identical income steam, investment objective and timeframe, but their asset composition may vary simply on account of their attitude towards risk. Before you indulge in any risky investments particularly equity funds, you must ask yourself : How much money could I stand to lose? How would your digestion be affected if you saw 40 per cent of your life's savings vanish in 4 years. But remember risk and reward go hand in hand. Higher the risk; higher the reward.

Time Horizon

Knowing your investment time horizon is critical for your asset allocation. If your time horizon is a longone, your asset allocation can be heavily weighted into equities for you can remain unperturbed at times of high volatility. However, if you want to invest for a short span, equities may not be the best of options. In such a case a safe steady avenue should be preferred.

There is a thumb rule for asset allocation : it says that whatever the investor's age, he should keep that percentage of his portfolio in debt instruments. For example, if an investor is 30, he should have 30 per cent of his investments in debt instruments. Usually the younger you are, the more speculative the investments you can hold. In any case, stocks are proven to provide best returns in the long term and stock funds provide best capital appreciation. As you grow old, your portfolio should become conservative. Capital appreciation remains an important consideration, but regular income and capital preservation take priority.

Income funds or bond funds are best suited under such circumstances. Besides, if your income steam is unsteadyor varies from time to time, your portfolio should contain less risky investments than that of someone with a steady income. If you are looking for high safety and liquidity with reasonable returns - short term debt funds and money market funds make the best offering.

A well developed asset allocation will always work well irrespective of the performance of various asset classes. Bond funds have clearly outperformed their equity counterparts in the bear phase after the 1994 disaster. Some stock fund have performed exceedingly well in the past two years. For instance Alliance '95 and Birla Advantage have registered fabulous appreciation the past year despite depressed market sentiments. And so have many private sector funds with their skewness towards hot sectors.

Such instances, though tempting, should not influence your asset allocation drastically. But before you can implement any asset allocation strategy, you must first determine where you stand currently. Determining the major asset categories andthe market segments of your own holdings may not be as straight forward as it appears at first glance. A disciplined asset allocation strategy will mean keeping track of the asset composition of your funds. Fund managers follow different styles of investing and they may or may not indulge in a dynamic asset allocation strategy. If the fund follows a steady asset allocation in all market weathers, it can be categorised easily and you can plan your investments taking the asset composition for granted.

However, funds that vary their holdings by large amounts - for instance those that try to time the market - are much more difficult to categorize. Funds that vary their allocations take away some of the control you have over your personal asset allocation strategy. The alteration in the asset profile from the fund managers side may not gel with your objective at times. For instance, a few of open-end income funds have been consistently maintaining a high cash component because of interest rate uncertainty sinceJanuary, 1998. Though it is a good risk management tool, the result is a lower yield on relatively liquid instruments.

For a small investor, a mutual fund is the most appropriate vehicle to practice asset allocation successfully. Funds not only provides diversification but also offers a family of funds to suit the investment objective of investors in different age groups with varied time horizons and occupations. Asset allocation is not a one-time exercise. Over time, most variables that determine the asset allocation change - particularly your investment objective and your risk preference. This calls for changes in your asset composition in accordance with the new requirements.

-- Value Research