Two ideas sit underneath almost every sensible investment plan: asset allocation and diversification. They are often used as if they meant the same thing. They do not, and knowing the difference helps you ask better questions about your own portfolio.
Asset allocation: the big division
Asset allocation is the way your money is divided between broad types of asset. For a mutual fund investor the main ones are:
- Equity: shares of companies. Higher potential for long-term growth, with large swings in value along the way.
- Debt: bonds, government securities and money market instruments. Generally steadier than equity, with interest-rate and credit risk.
- Other assets: some schemes also hold gold or other asset types as set out in their scheme documents.
The proportion you hold in each matters more to how your portfolio behaves than which individual schemes you pick within them. A portfolio that is mostly equity will rise and fall with the stock market whichever schemes it holds. A portfolio that is mostly debt will be steadier and will usually grow more slowly.
Diversification: spreading within each part
Diversification means not depending on any one company, sector, issuer or fund manager. A mutual fund scheme is already diversified to a degree, because it holds many securities. You can diversify further across market segments, across types of debt and across fund houses.
The purpose is to reduce the damage that a single failure can do. If one company in a portfolio of many does badly, the effect on the whole is limited.
What these two cannot do
It is important to be plain about the limits.
- They do not remove market risk. When the whole market falls, a well-diversified equity portfolio falls too. Diversification protects against the failure of a few holdings, not against a general decline.
- They do not assure a profit. A sound allocation makes the ride more bearable and the outcome less dependent on luck. It does not promise a result.
- More schemes is not more diversification. Several schemes in the same category usually hold many of the same securities. Owning all of them adds paperwork without adding much spread.
What shapes the right mix
There is no single correct allocation. It follows from your own situation.
- Time horizon. Money needed soon has little time to recover from a fall, so it generally belongs in steadier assets. Money not needed for many years can absorb more volatility.
- Risk capacity. This is about your finances: how stable your income is, who depends on you, what you owe and whether you have an emergency fund.
- Risk tolerance. This is about temperament: how you would actually behave if your portfolio fell sharply. A mix you cannot hold through a decline is the wrong mix, however logical it looks.
Different goals can have different allocations. A goal two years away and a goal twenty years away should not be invested the same way.
Rebalancing
Markets move, and the mix moves with them. After a strong run in equities, a portfolio that started with a moderate share of equity may hold much more than you intended, and so carry more risk than you chose. Rebalancing means bringing the mix back to where you set it, by directing new money to the part that has fallen behind or by moving money between schemes.
Two practical points. Moving money between schemes is a redemption and a fresh purchase, so exit load and tax may apply. Tax rules change, so check the current rules or speak to a tax professional first. And rebalancing works when it is done to a plan, at set intervals or when the mix has drifted by a set amount, not in reaction to news.
It is also normal to change the target itself as a goal gets closer, moving gradually towards steadier assets so that a late fall does not decide the outcome.
Hybrid schemes
Hybrid schemes hold both equity and debt inside one scheme, in proportions set out in the scheme documents. They can be a simple way to hold a mix, but read the asset allocation table before assuming how much equity a scheme carries. The name alone does not tell you.
Questions to ask about your own portfolio
- What share of my money is in equity, in debt and in other assets, taken across everything I hold?
- Does that share fit the time I have for each goal?
- How much would the portfolio fall, in rupees, in a severe market decline, and could I live with that?
- Do several of my schemes hold much the same things?
- When did I last check whether the mix has drifted?
Asset allocation is a decision you make deliberately or one that gets made for you by accident. Making it deliberately is most of the work.