Asset allocation is an investment strategy that targets balancing risk and returns by apportioning or distributing an investment portfolio among different types of asset classes such as equity, fixed income, bonds, bank deposits, real estate, and cash.

The asset allocation is per the individual’s financial goals and ability to tolerate or absorb risks. The asset allocation decision made by an individual is what works best for that person and depends upon that particular time and the investment timeframe or duration.

Two important factors are to be considered when deciding on asset allocation:

1. Time horizon or Investment Duration: The number of months, years, or decades for which the investment is made. Generally, investors with a longer time horizon tend to take more risk in their portfolio or a particularly volatile investment.

2. Risk Tolerance: This is the ability and preparedness to lose some of the investment or all of the investment in the process of seeking potentially higher returns on the investment.

Importance of Asset Allocation

Return of Investment of different asset categories within an investment portfolio can fluctuate (or go up and down) as per market conditions. Very rarely do asset categories move up or down uniformly. In other words, one asset category may do well while another asset category may perform poorly and fetch average or poor returns.

By investing in more than one asset category, possible losses in some categories are offset by the positive returns in other categories during volatile market conditions, thereby ensuring that the overall investment portfolio returns are still positive or good.

Investment advisors/experts believe that asset allocation is an important factor in determining the extent of returns for an investment portfolio. Asset allocation is based on the principle that different assets perform differently in changing market conditions and national/international economic situations.