Investing and portfolio managementModule 2, lesson 6 of 24
Asset allocation
How to choose the split between equity, fixed income and cash, why allocation drives most of a portfolio's swings, and how to allocate by goal and time horizon.
In this lesson
- Explain what asset allocation is and why it drives most of a portfolio's ups and downs.
- Compare the expected return and risk of different equity and fixed income mixes.
- Set an allocation for each goal using its horizon and the investor's capacity for risk.
- Explain how allocation should change as a goal approaches.
Builds on
- DiversificationAllocation diversifies across asset classes, extending the ideas there.
- Equity and fixed incomeAllocation mixes the asset classes explained there.
- Risk tolerance and risk capacityThe right allocation depends on tolerance and capacity.
On this page
In simple terms
Asset allocation is how a portfolio is split between broad asset classes: equity (shares and equity funds), fixed income (bonds, deposits and debt funds) and cash. It answers the most important portfolio question before any individual share is chosen: how much of my money should be exposed to the ups and downs of the share market?
Why allocation matters so much
Shares and fixed income behave very differently. Shares can rise or fall by a third in a year; good-quality fixed income usually moves far less. So the split between them largely decides how much the whole portfolio swings. Studies of fund portfolios have found that the mix of asset classes explains most of the variation in their returns over time, far more than the choice of individual securities.
Worked example: Three made-up mixes
Suppose, for this example, that over the long run equity is expected to return 12% a year with yearly swings (volatility) of 20%, and fixed income 7% with swings of 4%. Suppose also a bad year in which shares fall 35% and fixed income rises 6%.
| Equity share | Expected yearly return | Typical yearly swing | Result in the bad year |
|---|---|---|---|
| 20% | about 8% | about 5% | about −2% |
| 50% | about 9.5% | about 10% | about −14.5% |
| 80% | about 11% | about 16% | about −27% |
These figures are assumptions, not forecasts. They show the trade-off: more equity, more expected growth, and larger falls.
Setting allocation by goal
The goals lesson suggested treating each goal as its own pot. The allocation for each pot depends on:
- Time horizon: longer horizons can hold more equity, because there is time to recover from falls.
- Risk capacity: how much loss the goal can afford, as the risk tolerance and capacity lesson explains.
- Risk tolerance: how large a fall you can live with without abandoning the plan.
| Goal | Horizon | A possible allocation |
|---|---|---|
| Emergency fund | Any time | Cash and very short-term fixed income |
| Home deposit | 3 years | Mostly fixed income, little or no equity |
| Child's education | 10 years | More equity at first, shifting to fixed income near the date |
| Retirement | 25 years | Mostly equity, gradually reducing |
These are illustrations of the reasoning, not recommendations.
Shifting as goals approach
As a goal gets closer, a fall in equity becomes harder to recover from before the money is needed. Moving gradually from equity to fixed income and cash over the last several years before a goal, sometimes called a glide path, protects it from a late crash.
Worked example: A late fall
A made-up investor has ₹20 lakh saved for a goal next year, all in shares. Shares fall 30%.
| Value after the fall: 20 × 0.70 | ₹14 lakh |
|---|---|
| Shortfall | ₹6 lakh |
With only a year left, there is little time to recover. Had most of the money been moved to fixed income a few years earlier, the goal would have been protected.
Allocation is for everyone
It is sometimes said that asset allocation only matters for large portfolios. In fact, it matters most to people with small savings and essential goals, because they have the least room to absorb a large loss.
Keeping to the allocation
Markets move the mix over time: after a strong rise in shares, a 60% equity allocation may drift to 70%. Bringing it back to target is called rebalancing.
Why it matters
Asset allocation is the single most important decision in building a portfolio. It sets the likely range of outcomes, the size of falls you will face, and whether goals are likely to be met. Choosing it deliberately, goal by goal, makes it easier to stay calm when markets move.
Limitations
Expected returns and volatilities are assumptions based on history, which may not repeat. Correlations between asset classes change, sometimes rising in crises. No allocation removes risk; each trades one risk for another, for example less volatility for more inflation risk.
Common mistakes
- Choosing shares before deciding the allocation.
- Holding a near-term goal in mostly equity.
- Holding a long-term goal entirely in fixed income, losing ground to inflation.
- Letting the mix drift without rebalancing.
Try it yourself
- List your goals with their horizons.
- Choose an equity, fixed income and cash split for each, and write down why.
- Calculate what each pot would do in a year when shares fell 35% and fixed income rose 6%.
- Decide whether you could live with each result.
Key takeaways
- Asset allocation is the split of a portfolio between asset classes such as equity, fixed income and cash. It is the main driver of how much a portfolio swings.
- More equity raises expected long-term return and also the size of falls. More fixed income steadies the portfolio but lowers expected growth.
- Set allocation goal by goal, using the time horizon and the investor's capacity and tolerance for risk.
- As a goal approaches, shift gradually from equity towards fixed income and cash, so a late fall cannot derail it.
- Allocation matters for portfolios of every size. A small portfolio can be damaged by a bad mix as much as a large one.
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Terms used in this lesson
- Asset allocation
- The split of a portfolio between asset classes such as equity, fixed income and cash, the main driver of how much it swings.
- Fixed income
- Investments in which you lend money in return for agreed interest and repayment, such as bonds, debentures, deposits and debt funds.
- Diversification
- Spreading money across many investments, so that a problem with any one of them does limited damage.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.