Markets were down in the last few weeks, and many new investors saw their portfolios in red for the first time.
While the fall in the market is a part and parcel of investing, asset allocation can help you to manage the risk in your portfolio and optimise the returns.
Even the most experienced and knowledgeable investors can suffer from a corrective move in the market for it induces panic and causes them to make decisions that are against long-term investment goals.
During such instances, asset allocation might be the answer. Asset Allocation is an investment strategy where investors invest in different asset classes that are not directly correlated with each other.
This article discusses the nature of asset allocation, its usefulness when there is a market correction and strategies that can be implemented, enabling one to build stronger financial muscles.
You will see for yourself that by the end of the article, asset allocation is the most important pillar of a well-structured investment strategy.
What is asset allocation?
Asset allocation is the process of spreading investments over various classes of assets such as stocks, bonds, real estate and commodities, to achieve a certain given level of risk that is acceptable to the investor.
This strategy is based on the idea that different classes of assets behave differently with changes in the market and therefore, it is almost impossible for one downturn to adversely affect the performance of a portfolio as a whole. For example, while equities may suffer losses during a corrective move of the market, debt investments such as debt mutual funds or even gold might cushion the blow.
Why does asset allocation matter during market corrections?
Having a diverse portfolio helps protect you in times of turbulence:
1) Mitigating volatility: Market corrections induce a high degree of uncertainty. Equities can crash hard, but their decline might be cushioned by the positive behaviour of the other asset classes such as bonds or commodities. A diversified portfolio reduces overall volatility, providing smoother returns and protection of capital during rough waters.
2) Capital preservation: For investors nearing certain financial milestones, such as retirement or buying a big-ticket item, capital preservation is critical. During corrections, you can save your financial goals from market swings by placing investments into stable asset classes like debt instruments or cash equivalents.
3) Taking advantage of an opportunity: Usually, a correction opens up secret doors: many stocks fall below their fair value. An optimally allocated portfolio reserve with sufficient liquidity or enough exposure to defensive assets allows you to take advantage of that opportunity without forcing you to significantly overextend yourself into risk territory.
Strategies for effective asset allocation
A systematic approach can simplify complex market dynamics.
1) Assess your risk tolerance
Risk tolerance, the capacity to endure market fluctuations, is age, wealth, and investment purpose-dependent. Younger investors with time on their side may choose equities for capital appreciation, while older investors near retirement may prefer bonds or other conservative investments.
2) Adopt a multi-asset approach
A mix of different asset classes tends to pursue portfolio diversification
- Equities -A long-term growth driver.
- Debt – Safety, an offering of steady income and low risk.
- Commodities – Protection against inflation and volatility.
3) Adjust based on economic cycles
Economic conditions significantly affect the performance of your assets.
- Equities are likely to shine during bull phases.
- Bonds and gold serve as safety nets when the market is down.
Going forward, ensure that you are revisiting your allocation strategy periodically to make sure that it is in harmony with current market conditions.
4) Rebalance regularly.
With time, the market’s price movement may distort your original allocation. The rebalancing process ensures that you return to your target asset allocation. This makes sure that the risk that you are taking is in line with your risk tolerance.
Conclusion
The process of establishing a portfolio based on several classes of assets, balanced and rebalanced over time, will minimize risk, preserve capital, and extract appropriate advantages from market possibilities. In a period of economic instability and fast-moving markets, a sound asset allocation strategy cannot and should not go unseen.
Start now to build a portfolio that will survive a market correction and guide you toward long-term development.
Prasad Iyer
[Certified Financial Planner – CFP CM]