Indian cities and markets are flooded with small time shops and vendors. Passing by, you will find people who sell everything from samosas to sunglasses. Many of these entrepreneurs sell completely unrelated products, such as coffee and ice cream. This approach seems to be a bit odd, but it turns out to be working for them. When the weather is cold, it’s easier to sell hot cups of coffee. When the weather is hot, it’s easier to sell ice cream. By selling both, vendors reduce the risk of losing money on any given day. A similar activity in the world of finance is known as asset allocation.
Asset Allocation
Asset allocation means investing across different asset classes such as equity, debt, gold, bank FDs, Savings Account etc. Each of these asset classes have different risk profile and hence varying potential returns. Hence, asset allocation is considered as a critical building block of investment portfolio creation. However, this is not a one-time activity as it needs regular rebalancing.
By being invested in different asset classes, an investor is prepping the portfolio to work in varied market conditions, thereby eliminating any systematic risk. It not only helps to keep your portfolio on track, it also helps in keeping checks on recency bias (bias which gives higher weightage to recent winners). At the same time, it is important to recognise that asset allocation is an approach to manage investment risk and does not guarantee against investment loss.
Determining Appropriate Asset Mix
There is no one size fits all approach when it comes to asset allocation. It has to be tailor made as asset allocation is a highly personalised in nature. There are two broad factors which go in when deciding asset allocation.
Investment Horizon / Timeframe: Longer timeframe aids an investor to capitalise from market volatility. An investor with a shorter timeframe hence should consider investing in debt rather than equities.
Risk tolerance: An investor with higher risk tolerance is the one who can stomach relatively higher market volatility while in the pursuit for potentially higher returns. On the other hand, an investor with a lower risk tolerance is the one who is willing to forgo some potential return in favour of relatively lesser volatile investment options.
Portfolio Rebalancing
Everyone loves a winner. If an investment has done extremely well, most investors prefer to stay invested in that one outperforming asset class. But is that the best approach? Booking profits from your winners most often seem counterintuitive. What often forgets is that risk profile of a portfolio over time undergoes a shift and this phenomenon is often referred as “risk creep”.
Over time, the performance of different investments can shift a portfolio’s risk profile and hence it needs rebalancing from time-to-time. For example: Ms X is 50 yrs. old and she is a moderate investor with a clear objective of maintaining 50:50 (Debt: Equity) asset allocation. She wants to invest Rs. 10 lacs. As per her asset allocation, Rs. 5 lacs each will be allocated to debt and equity respectively.
After one year, at the time of portfolio review she realises that her equity portfolio has grown to Rs.7 lacs while debt is at Rs. 5.30 lacs, distorting her original 50:50 allocation which now stands at 43:57.
Here, she has two options:
1. Cut down equity exposure by Rs. 85,000 and allocate it to debt OR
2. Invest another Rs.1.7 lacs in debt so that original asset allocation is restored.
Another situation could be when her equity portfolio went down to Rs. 4 lacs while debt is at Rs. 5.3 lacs. Here, she will have to add more to equity through either of the ways mentioned above.
In effect, rebalancing is the process of restoring a portfolio to its original risk profile. Over time, investments made will deliver varied returns as a result of which the portfolio may bear little resemblance to original allocation. So, rebalancing becomes very important. Periodic rebalancing of portfolio to match your desired risk tolerance is a sound practice regardless of market conditions. One approach is to set a specific time each year to schedule an appointment to review your portfolio and make adjustments where necessary.
To conclude, asset allocation lays the groundwork for a solid portfolio but periodic rebalancing works its magic in delivering optimal risk adjusted returns over time.