Balance risk and return by asset allocation :: Business Line

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Asset allocation should be strategically planned in a way that it satisfies all your requirements with respect to liquidity, risk and return.

It's a well-known fact that buying when the markets are low and selling when they are high is the key to successful equity investing. However, it is the terms ‘high' and ‘low' in the investment rule that make the equation complicated. ‘High' and ‘low' are very relative terms and would be different for different persons even for the same stock or market.

Even as it is close to impossible to call a market top or bottom, human emotions, greed and fear, for instance, make things worse. It's not uncommon to see many retail investors investing when the markets are at high valuations and selling when the markets are about to hit the bottom. Exactly the opposite of what one needs to do!

INVESTMENT STRATEGY

So how does one circumvent this seemingly difficult challenge? While even professional fund managers and investors find it a tough task, laying down some strict rules and planning the investment strategy at the outset can certainly help. And it is here that an asset allocation strategy comes to the rescue.

What is asset allocation?

Well, asset allocation is a strategy that helps you diversify your portfolio across different asset classes and thus balance the risk and return of the overall portfolio. It ensures a fixed “allocation” by maintaining a specific proportion of different assets based on your risk tolerance, goals and investment horizon. An asset allocation, therefore, should be strategically planned in a way that it satisfies all your requirements with respect to liquidity, risk and return.

Though today asset allocation includes complex financial instruments and exotic derivatives, even a plain vanilla asset allocation can help you. A simple asset allocation talks about four basic asset classes – equity, debt, gold and cash.

DESIGNING PORTFOLIOS

But how do you arrive at the allocation to each of these assets? A simple thumb rule of financial planning says the equity allocation in your portfolio should be 100 minus your age. Theoretically, therefore, if your age is 22, the equity allocation in your portfolio should be 78 per cent (100-22) and the rest of the portfolio should be allocated to debt, gold and cash according to your requirements.

However, this simplistic rule may not apply equally on all investor profiles. For instance, the equity allocation of a 22-year old unmarried BPO executive cannot match that of a 22-year old married farmer, who is the only earning member of his family.

Ideally, moderate equity allocation along with fixed income investments is what should be asset mix of the young farmer. So, remember to choose your asset allocation depending on your income, age, requirements and other personal commitments.

But arriving at an optimal asset allocation mix is only the first step. The next critical task is to follow it diligently. You should regularly monitor your asset allocation and not deviate from the plan, regardless of market movements and opportunities. More often than not, investors usually tend to neglect their asset allocation strategies in volatile markets and invest where they see more value. Market hysteria also causes investors to either move out of a particular asset class or go overweight on some other. Eventually, the situation turns worse, leaving the investor trapped in an asset class that has shrunk to a level at which he/she can't afford to book a loss.

KEEPING IT DYNAMIC

Your asset allocation will need to dynamic given the nature of the markets. Regular rebalancing of portfolio, therefore, is required to match the set asset allocation.

There may be times when you find that over time, the income on your portfolio disrupts the overall asset allocation and therefore you may unknowingly have become overweight on a particular asset class.

For instance, a 20:80 equity debt allocation ratio would change to 25:75 if your equity and debt portfolio fetch 15 per cent and 8 per cent respectively in a year. Therefore, over the years, if you do not rebalance your asset weights, the portfolio can seriously tilt towards a particular asset class and become hazardous.

Remember what happened in 2008? During the economic crisis, while most fund managers resorted to high cash allocations, they were caught unaware when later in May 2009, following UPA's triumph, the markets had hit upper circuits. Even the most prudent fund managers were taken by surprise. As a result, most mutual funds missed the rally. Only the few that chose to stay invested and follow the asset allocation had managed to benefit fully from the rally. Even missing a few such good times in the markets, can make a substantial change to your portfolio yield over the long term.

Besides, an analysis of the historical market prices suggests that asset allocation accounts for 90 per cent of the portfolio performance! The lesson here is that it is very important to stay invested irrespective of market ups and downs and follow your set allocation, if you are looking for long-term wealth creation.