In nature, useful compounds such as table salt are often formed by combining potentially volatile elements such as Sodium and Chloride in a specific proportion. Similarly, creating an investment portfolio offering the optimal balance of risk and return also involves combining multiple potentially volatile individual investments such as Equity, Gold, Debt, etc. in a specific proportion. However, the magic formula that combines these diverse individual investments into an ideal portfolio often eludes investors.

Common Asset Classes and their Historical Performance

Before we go into discussing the various strategies of asset allocation, let’s talk a bit about the various asset classes and their past performance.

Among the wide range of asset classes, you can invest in, the most common ones that are used to create a diversified investment portfolio include Domestic Equity, International Equity, Debt, Cash, and Gold. The following is a tabular representation of how these 5 key asset classes have performed over the past few years:

As you can see in the table above, no single asset class has been the best or worst performer every year. In fact, in each of the past 5 years, we had a different top-performing asset class. No wonder that images such as the one shown above are usually shown with the tagline and warning – “Don’t put all your eggs in one basket”.

But just knowing about different asset classes is not enough. Figuring out how much exposure you should have to each type of asset is even more important and this where the concept of asset allocation comes in.

What Is Asset Allocation?

To put it in simple terms, Asset allocation is the process of investing across diversified asset classes”. The two key aspects of this definition are as follows:

• Asset allocation is a process: This is because the goal is to constantly balance the risk and return in an investor’s portfolio. The goal of this process is to achieve a better risk-adjusted return for the portfolio, i.e., get a higher return without increasing portfolio risk or maintaining the same level of return while reducing overall portfolio risk.
• Investments are made across diversified asset classes:  In the context of asset allocation, the term “diversified” refers to investments that are not correlated in terms of performance. To understand this better, consider the following table that shows the performance of the NIFTY 50 Index (which represents the performance of equities) vs. Gold for the 2000 to 2020 period:

Types of Asset Allocation Strategies

Asset allocation strategies are classified into 2 major categories – Strategic Asset Allocation and Tactical Asset Allocation.

1. Tactical Asset Allocation consists of techniques that aim to improve risk-adjusted portfolio returns by taking advantage of short-term opportunities while simultaneously staying on course to achieve long-term investment objectives.
2. Strategic Asset Allocation refers to techniques that are aimed at providing a long-term focus on your investment portfolio. There are two common techniques of strategic asset allocation – the age-based asset allocation technique and the risk profile-based asset allocation technique.

Let’s discuss these asset allocation strategies and techniques in more detail.

Tactical Asset Allocation

These days, the tactical asset allocation strategy typically involves the use of financial models to actively increase or decrease allocation towards specific asset classes in order to benefit from changing market/economic conditions.

You can avail the benefit of tactical asset allocation by investing in Dynamic Asset Allocation Funds that are also known as Balanced Advantage Funds. These funds use models to change their portfolio exposure to Equity, Debt, and Cash depending on changing market conditions to provide investors an optimal balance between risk and return.

Let’s take a look at the Equity Allocation in the portfolio of ICICI Prudential Balanced Advantage Fund over the past 12 months to see how tactical asset allocation works:

Strategic Asset Allocation

Strategic Asset Allocation Models are less automated compared to Tactical Asset Allocation and you can customize them according to your investment goals. There are two different strategic asset allocation techniques – Age-Based Asset Allocation and Risk-Based Asset Allocation.

1. Age-Based Asset Allocation

Age-based asset allocation is the simpler of the two techniques of strategic allocation.  In the age-based asset allocation technique, the investment decision is based on the age of the investor using the following formula:

Percentage of Equity in Portfolio = (100 – Age of Investor)

For example,  if you are 35 years old, the recommended percentage of equity in your portfolio should be = 100 – 35 = 65%.

While this approach does provide a starting point for asset allocation, it is clearly not sufficient especially as it does not factor in key variables such as your investment objective or your risk tolerance. The second type of strategic allocation technique – risk profile-based asset allocation is designed to overcome this limitation.

2. Risk Profile Based Asset Allocation

This technique of strategic asset allocation is a significant improvement on the age-based method as it uses the investor’s risk tolerance in determining how investments need to be allocated across different types of assets.

This method assigns investors the following 5 labels based on their ability to tolerate risk and volatility in their portfolio:

• Conservative
• Income
• Balanced
• Growth
• Aggressive

In this classification system, Aggressive Investors are the most risk-tolerant hence they have the ability to withstand the highest degree of volatility in the portfolio. This is because Aggressive Investors tend to be return-centric and understand the variability of portfolio returns in the short term. On the other hand, Conservative Investors are the least risk-tolerant and prefer to get consistent returns from their investment.

The following is a representation of how much portfolio volatility each of these types of investors is willing to tolerate in order to generate the desired level of performance:

After the investor is classified in one of these categories, the following recommended levels of asset allocation are generated by the model: