Question

Discuss the importance of asset allocation when developing a portfolio. In general, what is the conventional guidance in terms of allocating assets across the following three asset classes (equities, fixed income, and cash)? How would these allocations differ for a conservative investor, a moderate investor, and an aggressive investor? Explain your reasoning.

Answer 1

Asset allocation is one of the most important factors while investor decides on his investments for future financial goals works on the concept of diversification. An investor can diversify his monies in equity, fixed income, cash, commodities , etc based on his investment time horizon, risk appetite,

Different types of asset allocation strategies are being followed, the conventional way of investing is Age-based allocation.

Which means if a person is at the age of 25

He can invest 100- age in Equity and the rest in Debt

In this case, Equity investment is 75% and 25% in debt

Age - 60

Equity 40% Debt 60%

Cash should be maintained for at least of 3-6 months of your expenses as a contingency fund, which is readily liquidated and accessible. It can be invested in a savings account or short term money market instruments.

Based on investors risk appetite asset allocation can be derived:

Conservative Portfolio

As the name suggests a conservative investor has very less risk appetite. They prefer investing in avenues which provide guaranteed income.

Ideal for people who are nearby retirement

Moderate Investor

Investors have a higher risk appetite than a conservative portfolio, these investors have a medium level of risk tolerance and they can invest in mixed asset classes.

Aggressive

The investor takes chances and hopes to maximize his profits. The investor is willing to tolerate fluctuations in his portfolio.

Risk Appetite	Equity	Debt	Cash in Hand
Conservative	10%	85%	5%
Moderate	45%	50%	5%
Aggressive	80%	15%	5%

As the conservative investor is not willing to take many risks he can limit his investments in Equity, aggressive investors have a high-risk appetite so can allocate in the Equity portfolio.

Overall portfolio not only depends on the risk appetite but also the time horizon and the goal amount.

If an aggressive investor want to purchase a home in 2 years, and want to save the money for the same. He may not be able to allocate investments into Equity as his goals tenure is nearby, he would allocate more into debt.

Overall asset allocation can be derived by considering investors financial goals, the amount of the corpus required to reach the goals, his priority of goals, temure of goals and finally his risk-taking capacity.