As the Sensex has now crossed 6,400 and hit record new highs, it appears Indian investors have a strong appetite for equities at the moment.

So it may seem a little strange that I should raise the topic of asset allocation during this bull-run. But, in my mind, it is at times like these that the concept of asset allocation and the management of risk, should be at the forefront of investors' minds.

So what is meant by asset allocation?

Put simply, it means looking at the investments you hold in your portfolio and making sure that they're spread or allocated across different types of investments, such as equities (shares), bonds (debt instruments) and cash (deposit accounts).

If 100 per cent of your money is invested in equities at present, you would probably be enjoying some strong returns, and would question why you needed to consider anything else.

But will the path of the Sensex continue to be a straight line upwards? I very much doubt it. In fact, it wasn't so long ago that the newspaper headlines labelled 17 May as Black Monday!

Don't misunderstand me I'm not against equities at all. In fact, history has shown that they have consistently outperformed other types of asset classes such as bonds and cash.

So what should an investor do to ensure they enjoy the upside of the stockmarket while minimizing the downside? The answer lies with getting the right 'asset allocation'

Getting the right mix of assets is a must

We are all very different individuals and the first step to successful investing is to have a goal in mind. For instance, are you investing for your retirement or do you have an earlier need such as paying off your home loan? In short, how long are you planning to invest for?

A portfolio of just equities would be a very high risk strategy for someone a year away from needing the money. What if the stock market dipped just before you needed to sell?

Equally -- and this may sound strange to you - a young investor with a 20 year investment horizon who puts all their savings in a deposit account would also be following a high risk strategy.

While his money may be safe and never fall in value, in 20 years time would it have grown substantially enough to counter the effect of inflation?

To illustrate this, a person with Rs 10,000 in a savings account earning 3 per cent interest each year would have Rs 18,061 in 20 years time. That's a return of just over 80 per cent. But if inflation is about 7 per cent, that Rs 18,061 would only be worth Rs 4,668 in today's terms!

Build your portfolio

Once you have set your goal and the timespan required to reach it, the next step is to establish the type of investor you are.

For instance, would you say that your approach is likely to be cautious or bold? If so, how cautious? How bold? Or, do you think you'll fall somewhere between the two?

Naturally there are many ways an investor can build up a portfolio with an asset mix that suits their needs. The following pie charts suggest three sample portfolios to suit different types of investors.

These are only illustrations, and I would always recommend you consult a financial adviser to help build a portfolio that is right for your particular needs.

How often should I review my portfolio?

Asset allocation is not something you do just once and forget about. As asset classes rise or fall at different rates, over time the assets you have selected are likely to deviate from your original allocation. For example your portfolio may have become more cautious or more aggressive.

To ensure your portfolio reflects the type of investor you are, it is recommended you review your portfolios at least annually and make adjustments where necessary.

Again a financial adviser would be able to help you do this. It is also recommended to choose a neutral date each year to do this, perhaps your birthday or an anniversary, rather than reacting to an event in the market.

Change the mix over time

As time passes and you get nearer to your goal, you need to also think about changing your portfolio gradually. You may want to aim for strong growth in the early years by investing in equities, and then, as you get closer to needing your money, lock in any gains you have made and move into lower-risk instruments such as bond and cash investments.

To illustrate this, the following three pie charts show a portfolio whose assets have been changed the nearer the time to the goal. At the start of the period with a 25-year timescale the emphasis is on equities for the potential of long-term capital growth.

Later, with 10 years to go, the portfolio could become a little more conservative to consolidate some of the gains.

Part of the money stays in equities, while the remainder moves to lower risk bond and cash investments.

Finally with 5 years to go the aim is to preserve any gains made, with an emphasis on cash and bonds.

Stick to your plan

Working for a mutual fund business, I'm often asked whether the stock market is really a safe place to be, bearing in mind some of the volatility we've seen in the past.

My reply is normally to quote Peter Lynch, the legendary former Fund Manager of Fidelity's Magellan Fund in the US: "If you're going to need money within the near future to pay for college tuition or put a down payment on a house -- the stock market is not the place to be. You can flip a coin over where the market is headed over the next year. But if you're in the market for the long haul -- five, ten or twenty years -- then time is on your side and you should stick to your long-term investment plan".

Asset allocation should be the cornerstone of everyone's investment plan, that way you won't have to worry about where the Sensex is or where it's likely to go.

Ashu Suyash is Head of India Business, Fidelity Investments.

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