Asset Allocation for Dummies

Asset allocation is dividing and allocating your money (or investable assets) among different asset classes. For example, asset allocation may be as simple as dividing your money equally among stock index funds and bonds or dividing it among large-caps, mid-caps, and small caps. An asset allocation plan (also known as an investment plan) is important because without an investment plan, people tend to buy what they shouldn’t buy! I know a lot of people who invest their savings in the fund that performed the best last year. The chances of that fund performing better this year are pretty slim.

The importance of asset allocation can be best understood with the help of an example. Suppose I invest in the following manner according to my asset allocation plan:

25% or Rs. 25,000 - Large-Cap fund

25% or Rs. 25,000 - Mid-Cap fund

25% or Rs. 25,000 - Small-Cap fund

25% or Rs. 25,000 - Bond fund

Let’s say the different funds had the following rates of return this year:

Year I

+10% - Large-Cap fund

+08% - Mid-Cap fund

+15% - Small-Cap fund

-02% - Bond fund

My portfolio would look like this:

The formula for calculating return for one year is:

Beginning Amount * (1 + the rate of return )

25,000 * 1.10 = 27,500 Large-Cap fund

25,000 * 1.08 = 27,000 Mid-Cap fund

25,000 * 1.15 = 28,750 Small-Cap fund

25,000 * 0.98 = 24,500 Bond fund

Total Portfolio value at end of Year I = 107,750 or a 7.75% rate of return.

Most people would probably want to sell all of their bond fund and put it all in the small-cap fund. That’s human nature. Nobody likes to hold an investment that seems to be losing money. However, suppose the next year, the fund’s returns were like this:

Year II

- 05% - Large-Cap fund

+03% - Mid-Cap fund

- 20% - Small-Cap fund

+05% - Bond fund

At the end of Year II, the portfolio would like this:

27,500 * 0.95 = 26,125 Large-Cap fund

27,000 * 1.03 = 27,810 Mid-Cap fund

53,250 * 0.80 = 42,600 Small-Cap fund

The portfolio would be worth Rs. 96,535 (one year LOSS of 10.41%!)

Finally, had this person stuck with his asset allocation plan and reallocated 25% to each of the 4 funds, he would have had a loss of only 4.25% instead of 10.41%:

26,937 * 0.95 = 25,950 Large-Cap fund

26,937 * 1.03 = 27,810 Mid-Cap fund

26,937 * 0.80 = 21,550 Small-Cap fund

26,937 * 1.05 = 28,284 Bond fund

The portfolio would be worth Rs. 103,170 (one year loss of 4.25% which is MUCH better than the 10.41% loss)