Why is Asset Allocation important?

Risk and returns are directly related but risk is a double edged sword. If you take too little risk, you may not be able to make the money needed for your financial goals. On the other hand, if you take too much risk, you will expose your financial goals to uncertainties of capital markets. Right asset allocation means that you take the optimal amount of risk to meet your short term, medium term or long term financial goals.

  1. Irrational behaviour is very common in investing because greed and fear plays a big role in how we invest. When the market is high, people put more and more money in stocks expecting market to go even higher. When the market is low, people sell stocks fearing market to go even lower. Such irrational actions harm the long term financial interests of the investors. An asset allocation based approach takes emotions out of investing and keeps you disciplined.

    2. Investor psychology cycle showing the progression from greed to fear and back to optimism

    The image illustrates the investor psychology cycle known as the "Greed and Fear" cycle. A curved wave tracks investor sentiment through different market phases. The cycle begins with Optimism, followed by Excitement and Thrill, and reaches a peak labeled Euphoria. At this point, a highlighted marker identifies the "Point of Maximum Greed & Risk," indicating a stage where investors may take excessive risk due to strong market optimism. After the peak, the cycle moves downward through Anxiety, Denial, Fear, and Desperation, eventually reaching Panic. The lowest point of the cycle is labeled Despondency and is identified as the "Point of Maximum Fear & Potential," suggesting a stage where investor fear is highest and potential investment opportunities may be greatest. The cycle then begins to recover through Hope and Relief before returning to Optimism, completing the pattern. The diagram demonstrates how investor behavior and decision-making are often influenced by emotional extremes of greed during rising markets and fear during declining markets.

  2. Drivers of investment results
    We have seen that investors spend too much time on trying select best performing schemes. But historical portfolio returns analysis provides overwhelming evidence that asset allocation is the most important attribute of portfolio performance.

    3. Pie chart showing the drivers of investment results

    The image is a pie chart titled "Drivers of investment results." The chart illustrates the relative contribution of factors that influence portfolio performance. Asset Allocation represents the largest portion of the chart, accounting for 91.5% of investment results. The remaining contributors are much smaller, with Security Selection accounting for 4.6%, Other Factors accounting for 2.1%, and Market Timing accounting for 1.8%. The chart emphasizes that asset allocation, or the decision of how investments are distributed among different asset classes, has a substantially greater impact on long-term investment outcomes than security selection, market timing, or other factors. The visual highlights the dominant role of asset allocation in determining portfolio performance. Source: Determinants of Portfolio Performance, published in the Financial Analysts Journal, 2005.

  3. Winners keep changing
    Different asset classes outperform / underperform each other in different stages of investment cycles. Asset allocation may ensure a degree of portfolio stability in different market conditions and may give good returns across investment cycles

  4. Importance of Portfolio rebalancing
    Different asset classes outperform / underperform each other in different market conditions; without rebalancing, your asset allocation can deviate significantly from your target allocation.

Disclaimer:

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