What is Asset Allocation in Mutual Funds?

Mutual funds are one of the best investment vehicles that can help you achieve your financial goals. Apart from providing you with an opportunity to earn inflation-beating returns, they allow you to invest in various asset classes per your investment objective and risk appetite. Moreover, they offer high liquidity, which means that you can enter or exit your investments at any time. However, you need to adopt a prudent asset allocation strategy to make the most out of your mutual fund investments. If you’re hearing this term for the first time, then this article is for you. Here, you will learn what asset allocation is, why it is essential, and how you should do it. Let’s get started.  

What is asset allocation? 

In simple words, asset allocation refers to the diversification of your investment portfolio in various asset classes. Anyone who prefers to divide the risks of volatility in their investments should consider asset allocation.  

Asset allocation in mutual funds is the act of dividing your investment value into various types of mutual funds, including equity, debt, and hybrid funds.   

Why is asset allocation important? 

When you invest in mutual funds, you have the option to choose from equity and debt asset classes. These two differ from each other in terms of risks they contain and returns they can generate. While equity mutual funds can provide high returns over a long time, they are a bit riskier. On the other hand, debt mutual funds are relatively safer but offer lower returns than equity funds. 

Exposing all your investment to equity funds can be highly risky, whereas investing all your money in debt funds can result in lower returns. Hence, you need a balance of both, and that is why proper asset allocation becomes necessary.  

Below are some benefits of asset allocation in mutual funds: 

• It reduces risk

Each asset class responds differently to market volatility, and while some of them can show high fluctuations during the volatile market, others may not get affected that much. By diversifying your investment portfolio across different asset classes, you can reduce the overall risks of your investment. Even if one asset class in your portfolio goes down in value, you won’t incur high losses. 

• Provides optimal returns 

Returns from mutual funds are market-linked, and not all funds will perform well at the same time. By diversifying your mutual fund portfolio across asset classes, you allow yourself to earn from other funds when some of them are not performing that well. You can even choose multiple categories of mutual funds, such as large-cap and small-cap funds, within the same asset class. 

• It eliminates the need to time the market 

The market cycles keep on changing, and it is challenging and stressful to keep track of every mutual fund to time your entry and exit in it. If you adopt a proper asset allocation strategy and diversify your fund portfolio accordingly, you are not required to time the market. You can automatically reap the rewards of rupee cost averaging. 

• Helps in achieving financial goals 

Proper asset allocation is very crucial to achieving your financial goals. You need to ensure that your portfolio is aligned with your investment objectives, risk appetite, and time horizon.  

What should be the right asset allocation strategy for you? 

No one fits all strategy for asset allocation. It can vary from investor to investor based on a number of factors, such as age, income, financial goals, and risk appetite. Here’s how these factors should influence your asset allocation strategy: 

• If you are a young investor, you can adopt an aggressive investment approach as you have a long time horizon in your hand. You can allocate 60 to 75 percent of your investments to equity mutual funds and the remaining 25 to 40 percent in debt funds. However, if you’re nearing your retirement, you can take a conservative approach and allocate a large portion of your investment to debt mutual funds.

• Similarly, if you’re investing for your long-term financial goals and have a longer time horizon, you can increase your investments in more volatile equity mutual funds. In contrast, if you’re investing for short-term goals, it’s better to have more of less risky debt funds in your portfolio.

• Again, if you are someone who can tolerate a bit of risk on your investments, you can keep a high percentage of equity mutual funds in your portfolio. Else, if you’re a risk-averse investor, allocate a large portion of your investment to debt funds.

The parting words 

By now, you must have understood the importance of asset allocation and how you should do it. However, if you are still finding it difficult to diversify your mutual fund portfolio as per your risk appetite and investment goals, you should take the help of a financial advisor who can guide you in a better way.