Portfolio risk arises from the variability in performance across various asset classes. Asset classes are by definition those securities which can be grouped by shared characteristics, law, regulation and their behavior in the market over time. Assets are classified by their risk and return behavior in any given market environment.
Asset classes perform differently due to the inherent nature of the asset type. This introduces the need for the asset allocation practice, the science of allocating wealth across various assets.
Asset Allocation is the process of deciding how to distribute wealth among various asset classes and sectors. Asset classes have fluctuating returns and correlations over different time horizons. No one asset class tends to outperform others consistently. Therefore, it is critical to diversify and adapt your portfolio to the dynamic investment climate.
Understanding how assets perform helps in achieving a more stable return variability through asset allocation decisions. Return variability is the degree to which actual returns vary from expected returns on the investments made. Changes in asset allocation decisions have been seen to:
Asset allocation is the major contributor to portfolio risk and return. Hence it is important to spread the asset across equity, debt, structured products, private equity, real estate and other alternates to build a portfolio that balances both risk and return well.