Asset allocation is an important decision-making process that seeks to match the needs and objectives of the investors with his risk profile. Depending on the specific needs and objectives of investment and the specific risk profile appetite, the allocation would have to be done accordingly.
There are four broad categories of asset classes available for investment, viz. equities, debt, commodities and real estate. While deciding on asset allocation between these categories, one has to take into account three crucial parameters, namely, income level, age of the investor and the risk profile. Let us look how these parameters play a crucial role in determining the kind of asset allocation that would be suitable for an investor.
Income level: The income level is crucial because the higher the income of the investor, the higher would be his ability to take risks, and vice versa. A person earning Rs 1 lakh per month would be able to risk an amount of Rs 10K effortlessly than a person earning Rs 25K because the amount of risk is 10% for the first person, while it is 40% for the second person. So, the person earning Rs 1 lakh can consider buy stocks or equity mutual fund units worth Rs 10K every month, but the person earning Rs 25K cannot take the risk of buying stocks or equity mutual fund units worth Rs 10K as it would be took risky considering his level of income.
Age level: A 30-year-old person can afford to go for high risk investments such as stocks and equity mutual funds because even if he suffers heavy losses, he has plenty of earning life left to recoup his losses. So, obviously a 30-year-old person can have a high risk appetite as he can put the losses behind and can look forward to his future earnings.
He can therefore allocate higher proportion of his earning towards equities and equity-oriented instruments and reap higher rewards, and allocate lower proportion towards debt and debt-oriented instruments, gold and real estate.
On the other hand, a 50-year-old person cannot afford to invest a high proportion of his income and savings in highly risky assets such as equities as he does not have too much time left before he hangs up his boots, so if he suffers heavy losses, he would have very little time left to recoup his losses and also build up a decent retirement kitty to fend for himself and his family after retirement. Hence, for those past prime of their life, the risk appetite would be low and, therefore, investment in debt and debt-oriented instruments, gold and real estate (land, shops, flats, etc.) are best suited for them.