Four Principles of Asset Allocation

Asset allocation helps in getting the right balance between risk and return by investing in a variety of assets. One common mistake investors make during allocation of assets is to take more risk required to accomplish the desired returns. Risk return trade-off 

compensates an investor for assuming risk. Investors manage or balance risk and return 

through asset allocation and select investments that offer high return than expected for 

the risk they are ready to assume. 

Asset allocation is the most important process for an investment management.There are  four principles for asset allocation, they are 

• Risk rewards trade-off; 
• Risk depends on the investment horizon; 
• Rupee cost averaging; 
• Risk depends on the financial situation.

Risk and Rewards are Related: Risk and rewards is a risk reward trade-off. With 

investment rewards can be increased only by assuming greater risk. It is important in 

investment management. Higher risk is the price one pays for more generous rewards. 

Risk Depends on time Horizon of the Investment: The actual risk in stock or bond 

investing depends on the length of the time an individual holds the investment. Length 

of the holding period and the risk capacity of that investment are inversely related. It is 

observed that age and the likelihood of holding period of the investment program not 

only affects the risk one assumes but even determines the amount of risk involved in 

any specific investment program. Even the risk of investing in common stock decreases 

with the length of time they are held. Buy and hold strategy is suitable and adopted in 

such conditions. The more the individual’s investment horizon, the stocks outperform 

the bonds. 

Rupee Cost Averaging: Rupee cost averaging is a timing strategy. It is investing equal amount of Rupee over a period of time in a particular investment. It is also called as constant Rupee plan or pounds cost averaging or cost average effect. In this investment strategy, the investor has to decide on three parameters – investment amount, investment period of time, investment frequency. It is assumed that applying this 

strategy reduces the risks of investing in stocks and bonds. It avoids investor in investing all the money in stocks or bond market at the wrong time. The investor makes equal Rupee investments buying fewer shares when prices are high and more shares when prices are low. Rupee cost averaging strategy will not solve all investment problems. As a matter of fact, there is no plan that protects any investor against loss. 

Risk Depends on total Financial Situation: The kinds of investments that are 

appropriate for an investor depends on the sources of income. The earning ability of an I

nvestor and capacity of risk is related to the age of the investor