Role of Asset Allocation and Diversification

Asset allocation and diversification are key components of investment strategy that balance risk and return. Their proper utilization makes your portfolio stable and resilient.

Understanding Asset Allocation

Aggressive Allocation: Investors with high-risk tolerance and long-term goals allocate more stocks and high-growth assets in their portfolio.

Moderate Allocation: Portfolios with moderate allocation have a balanced distribution, which includes both equity and fixed-income securities. This strategy is suitable for moderate risk and returns.

Conservative Allocation: Conservative allocation is suitable for investors with low-risk tolerance and short-term goals, which will include more bonds and fixed-income assets.

Benefits of Diversification

Diversification is an essential element of your portfolio as it helps manage risk and stabilize returns.

Reduces Risk: Diversification reduces the chance of losing your capital because the poor performance of a single asset class will not have a negative impact on your entire portfolio.

Balances Returns: Investing across different assets and sectors balances returns, with some assets outperforming in the short-term and some providing growth in the long-term.

The Power of Compounding in Long-Term Investing

Compounding is a powerful force in long-term investing that helps returns grow exponentially. Compounding simply means reinvesting your earned returns to earn additional returns on them.

How Compounding Works

In compounding, the returns earned on your initial investment are reinvested at the end of each cycle, which helps you generate “returns on returns”. This process accelerates over time and provides exponential growth.

Early Start: The sooner you start investing, the more you can benefit from compounding. This is why the impact of compounding increases over time.

Regular Contributions: Contributing regularly and reinvesting your returns further enhances the effects of compounding.

Practical Example of Compounding

If you invest Rs.100,000 at 8% annual interest and reinvest it for 20 years, it can grow to Rs.466,096. This growth is not just on the initial contribution but also on the compounded returns that increase over time.

Investment Time Horizon and Patience

The investment time horizon defines how long you plan to hold your investments. Determining the time horizon impacts your risk level and asset selection decisions.

Short-Term, Medium-Term, and Long-Term Horizons

Short-Term Horizon: Short-term investments are those that last for 1 to 3 years and are suitable for assets with lower-risk and stable returns such as bonds and fixed deposits.

Medium-Term Horizon: Medium-term investments are those that last for 3 to 5 years and are suitable for medium-risk investments such as balanced funds and dividend-paying stocks.

Long-Term Horizon: Long-term horizon investments are planned for more than 5 years. These include high-risk and growth-focused investments such as stocks and real estate that grow over time.