Asset allocation is an integral component of financial planning. However, investors are often unsure what it actually means and does for them. After all, why should you even think about asset allocation?
In this article, we will try to help you understand why asset allocation helps you manage the risk of losing money rather than increasing returns.
Specific Objectives require specific growth rates accounting for risks
Supposing, you have a child education goal target of Rs 1 crore after 15 years and could save Rs 25,000 every month, then you need a return of 8.3% annually.
This required rate of return in turn will define if you need to take high or low risk through exposure to growth assets.
However, that’s not all. While you might need to take risks in order to reach your goal, you might not have the loss tolerance defined by the maximum amount of uncertainty one is able to accept.
Notional Loss – how much can you take?
In a 10% market correction – you might feel ‘okay’ as it only takes 11% gain (from those levels) to recoup entire losses.
20% loss is ‘harder’, as it takes a 25% gain to break even.
40% loss might seem ‘overwhelming’ as it takes 67% gain to recover losses
And a 50% loss, requiring a whopping 100% gain.
The following table gives an inkling of the challenge emanating from a sharp market drawdown. Most investors start getting nervous when the market tanks beyond 30% and panicking beyond 40%.
So, the big question is – What’s your bearable drawdown?
Accordingly, establish a maximum loss plan.
Markets and corrections – what to do about it?
Since 2000, Indian equity markets on six occasions witnessed more than a 30% correction in a calendar year. In 2000 and 2001, equity markets were down even more by 43% and 42% respectively while in 2008, it was down by 65%.
So, let’s assume the probable maximum loss is 40% in a year on most occasions.
Next, you need to evaluate the maximum loss you are willing to take in your portfolio. Let’s say it is 20%.
Then, divide your personal portfolio maximum loss by maximum stock market loss that could probably happen.
In this case, it would work out to
0.20 divided by .40 = 0.50 or 50%!
So, your target equity allocation should be roughly 50%.
Don’t ignore equity components
Asset allocation is not just about deciding the equity-debt allocation mix. It is more important to decide its sub-components as well.
Investing in midcap and smallcap funds, for instance, carries higher risk and could therefore have the potential to see a larger portfolio drawdown. Similarly, investing in a few stocks or ESOPs runs the risk emanating from its non-diversification.
Dynamic asset allocation
Valuation of equity and debt changes frequently and asset allocation needs to dynamically change to reflect these changes. So, for instance, in 50:50 equity: debt allocation, if equity appreciates by 30% in a year, while debt portfolio appreciates by 6%, equity: debt mix will get modified to 55:45.
To ensure the portfolio doesn’t have a potential drawdown that is more than what is palatable, reduce the equity stake to bring it back to 50% levels.
Similarly, in a core-satellite portfolio structure, the intent should be to protect the core portfolio – the mainstay of one’s investor portfolio – from the vagaries of the satellite portfolio, which tend to be riskier.
After losing 50% in a year, it would take a 100% gain to come back to the same levels. And staying invested can make the process faster. How is that? Often investors lose out on market gains by trying to time the market.
A study by Motilal Oswal shows that more than 50% of the best 30 days in the last 30 years happened during bear markets. And exiting it could mean losing out on the opportunity
In the above instance, if the market were to gain 10% every year after a 50% correction, it would take 7 years (and not 10 years, thanks to the power of compounding) to recoup all your losses.
During the bull run of 2002-2008, Nifty 50 was up by nearly 6 times from 1,100 in Jan ’02 to 6,300 in Jan ’08. It grew at a CAGR of 33% per annum. However, the trajectory was not smooth during this period. It went through seven double-digit percentage falls – two of them as sharp as 30%.
Similarly during the period May ’14 till Aug ’21, Nifty 50 grew 2.5 times at a CAGR of 13%. In intermittent times it witnessed five drawbacks of over 10%, two of which were more than 20%. So, stay invested to reap the benefit of equities.
The best of investors focus on risk management that fits their long-term goals. Good return eventually follows if you stay put.