Chapter 2 of 5
Asset allocation basics
Understand exposure, correlation, rebalancing and the difference between a portfolio weight and a product label.
In this chapter
Classify the economic exposure #
Asset allocation describes how a portfolio is divided across categories such as equity, fixed income, cash and real assets. A product name can conceal a mix of exposures: a fund holding shares and bonds is not a separate risk-free category merely because it is packaged in one product.
Equity is a residual ownership claim. Fixed income has contractual cash flows but still carries credit, interest-rate and liquidity risk. Cash provides immediate nominal liquidity but can lose purchasing power. Real assets can introduce storage, transaction and price risks.
Weights and relationships both matter #
Portfolio return is the weighted sum of component returns over a matching period, ignoring complications such as interim flows. Portfolio risk also depends on how those components move together. Two volatile assets can sometimes reduce combined variability if their movements are imperfectly related.
Historical correlation is an estimate, not a constant law. During stress, assets that looked independent may fall together. Diversification should examine business, sector, issuer, currency and liquidity concentrations rather than counting product names.
Rebalancing is a rule, not a forecast #
After different returns, portfolio weights drift. Rebalancing restores a chosen allocation by adjusting exposures, subject to costs, taxes and practical constraints. It should follow a defined review rule rather than a claim to know the next market movement.
There is no universal percentage mix appropriate for every reader. The acceptable allocation depends on goals, obligations and capacity for loss. This chapter explains the arithmetic so that an allocation can be understood and questioned.
Decision lab: Allocation risk is driven by exposures #
An illustrative portfolio holds three funds whose largest exposures substantially overlap. Counting three fund names does not establish diversification. Look through holdings, styles, currency and liquidity to identify shared drivers.
Stress the portfolio by driver rather than product label. Apply a common equity decline and an adverse currency move to a hypothetical allocation. Compare the cash available for a fixed liability before and after the shock; do not infer future correlation from a calm recent period.
Hypothetical worked example
A two-asset portfolio drifts
A fictional ₹1,00,000 portfolio starts with ₹60,000 in one exposure and ₹40,000 in another. If the first rises 20% and the second is unchanged, the total becomes ₹1,12,000.
The first exposure now represents ₹72,000 ÷ ₹1,12,000 ≈ 64.3%, rather than 60%. Restoring the original illustrative weights would imply ₹67,200 and ₹44,800, before costs and taxes.
That exercise does not prove the original allocation was suitable. It shows that doing nothing is also a decision: it permits weights to change. A rebalancing policy must consider the friction involved, not just the clean spreadsheet.
Common mistakes
- Assuming several funds have different exposures without checking holdings.
- Calling a fixed-income product capital-guaranteed without reading its terms.
What does rebalancing primarily do?
Make this chapter useful
Can you defend the reasoning?
Before moving on, answer the self-check in your own words and write why each alternative fails. Use the worked example to test that explanation. Then apply it in the module research task; keep the assumptions and the evidence that could change your answer.
Sources and further reading
Further-reading references from the curriculum source list. Contract sizes, expiry calendars, settlement references, margin parameters and tax treatment can change; verify the current operative documents for the actual product. Worked figures are illustrative, not current quotes.
Progress is stored only on this browser.
Back to Investing essentials · Learning library · Calculators
General financial education. No securities recommendation, assured outcome or personal advice. Read the risk disclosures.