Importance of Asset Allocation

The year 2022 has thrown up several surprises. The impact of all the developments in the year on the overall economy and hence personal finances of many people has been critical. Take, for instance, the stock market, which has been a tumultuous roller-coaster ride. In January 2022, the benchmark Nifty 50 was at an all-time high. By mid-June, the Nifty had witnessed sharp corrections of more than 10 per cent twice from its peak. The impact was severe, especially on those who needed to liquidate their investments for financial goals scheduled during the year. In fact, many investors were caught in a trap, confused about whether to hold on to their stocks and wait for the tide to turn or make a quick exit before the losses could pile up further.

This would make an investor think: what should I do differently so that I am not caught unaware like this. To be fair, there will always be an element of risk associated with investments. What, however, can be done is that the risk can be managed intelligently. Most people are confused when it comes to deciding where to invest their savings. Some of them put their money into equities in expectation of higher returns without giving a thought to the risks involved, while the risk-averse people simply opt to invest in fixed income instruments to derive stable returns. Some may prefer to buy gold and keep it for posterity as a family heirloom.

Since these people do not have a proper asset allocation plan in place, they tend to invest in a haphazard manner. As a result, they may be taking undue risks investing a large chunk of their savings in equities, or they may be compromising on the returns by parking a bulk portion of their savings in fixed deposits, or they may be missing out on short-term returns by investing in gold or real estate. More importantly, they may not be able to achieve their financial goals if they keep investing haphazardly. Investments should not be for the mere sake of parking your surplus funds. They should be backed by an intelligent approach so as to make your money work for you and generate wealth. This is where the concept of asset allocation comes into the picture.

Understanding Asset Allocation
The most fundamental decision that you will ever take about your investment and portfolio is the allocation of your funds into different asset classes to contain the risk involved by investing in a single asset. Asset allocation lowers risk by dividing your investments among different asset classes that are most probably not correlated to each other. Every asset class has its own characteristics and different asset classes behave differently in different market conditions. For example, the returns on the equity shares of a company would depend upon the growth in profits and the scalability of the business. 

This translates into the possibility of a higher long-term return if the company is managed well and the performance is good. On the other hand, returns from fixed income securities such as fixed income bonds of a company would depend on the ability of the company to generate enough cash to pay interest even if the company is not growing. This translates into steady periodic return with limited possibility for capital appreciation. This difference in characteristics of different assets makes asset allocation work in a perfect way. Further, to decide the appropriate proportion in which you need to invest in those asset classes, you need to first assess your risk appetite. 

The reason behind the same is that every asset class has its own risk and every investor has a different risk appetite. Say, for instance, if you are someone who cannot stomach losses greater than 15-25 per cent, then you are a conservative investor. Hence, you should be investing majorly in debt and gold than in equity. Other key factors that need to be taken into account for optimal asset allocation include return expectations, income level, age and financial goals. Also, asset allocation works better if it is periodically rebalanced. Further, with regards to an asset allocation strategy, we need to remember that typically the younger you are, the more risk you can afford to take.

As you get older and closer to retirement, you will probably be less interested in the growth of your portfolio and more interested in capital preservation or the conservation of wealth, thereby protecting the value of your portfolio from any declines. Preserving your portfolio as you reach your desired retirement age becomes more important since a large decline in the value of your holdings can affect your retirement lifestyle, or even make it impossible to retire according to your plans. There are also factors like inflation to be taken into account since your investment corpus may be negatively affected by any rise in the cost of living.

The Rebalancing Act
As different assets behave differently, they would have different returns in each period. Therefore, your original asset allocation would change at the end of a period. Assume, for instance, you have invested ₹50,000 in equity and ₹50,000 in debt. This means you have 50:50 asset allocation. Let’s further assume that in the next year, equity gave 10 per cent returns and debt gave negative 2 per cent returns. Then the value of your equity would be ₹55,000 and that of debt would be ₹49,000. The value of your portfolio is now ₹1.04 lakhs. This will bring your asset allocation to around 53:47 as against 50:50. 

Therefore, to restore it back, you need to rebalance. This means you would need to sell one asset and buy another to maintain the asset allocation ratio. In our example, to restore asset allocation of 50:50, you would need to sell ₹3,000 from equity and buy ₹3,000 worth of debt. This is how rebalancing works. Rebalancing your portfolio helps you to further control the risk by ensuring that your portfolio is not dependent on the success or failure of one asset class. Without rebalancing you might be exposed to too much risk to a particular asset, which might work when in a bull phase but will spell disaster when the markets enter a bear phase. 

Asset Allocation Strategies
Here are some important strategies that you could keep in mind:

1. Strategic Asset Allocation — Strategic asset allocation works with an aim to construct ‘efficient’ portfolios. Efficient portfolios are the ones that maintain an optimal mix between different asset classes such as stocks, bonds and cash with a focus on maximising returns for a particular level of risk. The strategic asset allocation approach involves holding on to original allocation over long periods, generally spanning a decade or more. After establishing long-term strategic allocation targets, investors will need to periodically rebalance portfolio weightings back to those target allocations. 

To keep investors inclined towards the right direction for the long term, appropriate asset allocation plays an important role. Strategic asset allocation underlines a framework for an investor’s portfolio by appropriately aligning their asset mix with long-term investment goals and objectives. Strategic asset allocation can be challenging in volatile market environments as rebalancing allocations back to strategic targets may lead to buying stocks in periods of market stress and economic uncertainty. As such, while using the approach of strategic asset allocation, it is also important to be aware of the various turns in economy and stay alert to the ups and downs of the stock market.

2. Tactical Asset Allocation — Tactical asset allocation establishes a baseline mix of assets that are suitable for an investor’s risk tolerance and investment objectives. Instead of merely deciding on an asset mix and following the same, the portfolio weightings will be adjusted actively based on shortterm or medium-term expectations for economic conditions, valuations, market cycles, etc. This approach holds the potential to amplify returns, lower portfolio risk and increase diversification which counts as important benefits of the same. These tactical allocation changes or shifts are taken into account and implemented to generate superior risk-adjusted returns in comparison to the otherwise strategic asset allocation approach.

Here is an example to explain the theory. An investor decides to reduce his allocation to domestic stocks to below normal or strategic allocation levels and increase weightage to international equities on the back of favourable short-term or medium-term view of international stocks. This constitutes tactical asset allocation based on future market views. The tactical asset allocation process is named as a success if the tactical investment decisions achieve the goals of generating superior risk-adjusted returns compared to a strategic asset allocation approach in reality. 

Asset Allocation and Rebalancing
The reason why asset allocation is important is because not all the assets will outperform or underperform at the same time. Each asset class will react to an economic development in its own way. In effect, the presence of various asset classes in a portfolio will ensure that the adverse development in a single asset class will not weigh down heavily on the portfolio. Easy to say, but in practice, this could be a little challenging to implement. The reason is that most retail investors could find it difficult to either execute decisions on rebalancing their investments, or would hesitate due to either fear or greed.

For instance, an investor would have been sceptical about reducing allocation in equity in January 2022 in anticipation of the market scaling further new highs. In fact, most investors end up buying more in such situations. On the other hand, an investor would have been quite pessimistic in March 2022 and June 2022 when the markets were in a freefall. In this case, many investors would have even sold off their existing investments, even with a loss, due to panic. What they should have done is quite the opposite. This is why asset allocation is easy to understand but is difficult to execute.

With the right asset allocation in place it is no longer necessary to time the markets. The cycles of different assets are always in a mode of transition. As a result, keeping track of varying asset classes and timing the entry and exit of the various asset classes can be stressful and challenging for many investors. Also, with optimal asset allocation, you can meet your liquidity demands as and when the need arises to meet your emergency requirements. Wise investors often allocate to various asset classes at the same time, including equity, Debt Funds, gold, real estate, and so on. For instance, while investment in real estate is a long-term proposal because it does not offer immediate liquidity, gold as an asset class can be sold if there is an urgent requirement for cash. The same is the case with equity.

"The most fundamental decision of investing is the allocation of your assets: How much should you own in stocks? How much should you own in bonds? How much should you own in cash reserve? Jack Bogle, Legendary American investor and founder of The Vanguard Group"

Designing Personal Asset Allocation
To begin with, asset allocation and a goal-based investment process go a long way in creating the groundwork for long-term investment success. This approach allows you to focus on capital safety while investing for the short term as well as on safety and growth for the medium term while staying ahead of inflation and investing for the long term. Once asset allocation sets the framework, the key is to choose the right investment options and follow the right strategy to benefit from the chosen asset classes. It’s difficult to recommend specific portfolios as one size does not fit all. Every individual will have different goals, timeframes, risk tolerances and personal financial situations. 

Nonetheless, we will try to generalise it and design an asset allocation plan based on financial goals. First, different financial goals should primarily be identified based on the timeframe. Your time horizon plays a key role in determining your asset allocation, which in turn determines the attendant risks and probable returns over a defined time horizon. Hence, once a time horizon is assigned to a goal, you must remain committed to it irrespective of how the market behaves and continue your investment process uninterruptedly. This approach not only helps in reducing the impact of volatility on your portfolio but also hastens the recovery process by bringing your average cost down.

Once you have categorised your financial goals in terms of different time periods, the next step is to divide them into needs retirement, child’s education, medical care, child’s wedding and others, while there are some financial goals such as international vacation or upgrading your mobile phone every year which are avoidable and can be postponed. For instance, there is now a new trend of purchasing a second home, which is often called a weekend retreat. This, however, is not an important goal. The following table is a rough guide to your asset allocation based on your financial goals and their criticality.

"The difference between success and failure is not which stock you buy or which piece of real estate you buy, it's asset allocation Tony Robbins, American Author"

You should also understand that as and when goals move towards their horizon, asset allocation should also change accordingly. For example, when you are 30 years old and saving for your retirement, you can invest up to 80 per cent in equity. As you become older and reach the age of 55, your asset allocation should now match with short-term goals and 100 per cent of your asset should go towards debt. Besides, within the broader asset class of equity and debt there are sub-asset classes. For example, within equity you have Large-Cap, Mid-Cap and Small-Cap stocks. For a conservative investor, equity allocation should be made towards large-cap stocks. A moderate or aggressive investor can invest a large chunk of his equity allocation in mid-cap and small-cap stocks only if the goal is beyond 10 years. In case of debt funds, investors should try to match the duration of the bond fund with the financial goal. For example, if your goal is three years away you can chose a debt fund that has Macaulay duration of three years. What we have discussed above is only one of the many approaches one can take to arrive at appropriate asset allocation. Ultimately, it is important to first chart your financial needs and wants and then map an investment path that will provide the funds as and when you require them. And as mentioned earlier, keep rebalancing the portfolio at regular intervals.

Conclusion
There are various studies that favour asset allocation and periodic rebalancing of your portfolio. In 2003, The Vanguard Group did a study using a 40-year database of 420 balanced mutual funds. It found that 77 per cent of the variability of a fund’s return was determined by the strategic asset allocation policy. Market timing and stock selection played relatively minor roles. Asset allocation basically helps in reducing risk through diversification across various asset classes. Historically, the returns of stocks, bonds and gold have not moved in the same direction. In fact, market conditions can lead to one asset outperforming in a given period and causing another to underperform. Therefore, at a portfolio level it results into less volatility for investors as movements in them offset each other. 

The table above shows the return correlation between different asset classes over 20 years from April 1998 to March 2021. We all know the importance of a balanced diet. We have spent our entire childhood with elders who have told us to have more greens and seasonal vegetables. Eating healthy food promotes our physical and mental health. Similarly, we must also focus on having a balanced investment approach. And asset allocation can help us ensure that we have a balanced investment portfolio. The goal is to balance risk against reward—i.e. to get reasonable returns without taking unreasonable risks. As can be seen from historical studies and analysis, asset allocation and rebalancing is one of the most effective investment strategies when compared with investment in individual assets. 

Risk profile and financial goals are some of the major aspects that would help you to define your asset allocation. Also, this strategy would be more suitable for retail investors who have lack of knowledge and time to manage their own portfolio. In addition, this strategy would be for those having financial goals to achieve. However, for those with only wealth creation goal in place, he or she should consider a dynamic asset allocation strategy. With a dynamic asset allocation strategy, one would require to adjust asset allocation depending upon the market situation. All in all, we can say that asset allocation with rebalancing strategy does give you better investment experience with comparatively less risk.