While driving on a highway, you will often find vendors on the streets selling umbrellas and sunglasses. It’s an odd combination. After all, what’s the probability of buying both these items? Very low. If it’s raining, you buy umbrellas and if there is a clear sky, well you slip on sunglasses. But, buying both at one time is unlikely.
While buying both makes little sense for you, selling them makes ample sense for a vendor. Since he is catering to all weather conditions, and his sales keep ticking.
By diversifying the least associated product lines – the street vendor has reduced the risk of losing sales in a day.
Asset allocation is something like that.
What is its definition?
It is defined as an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio, according to the investor's risk tolerance, goals and investment time frame.
While it is about investing across different asset classes, it is much more than mere diversification of a portfolio.
First of all, let’s look at the major asset classes.
Traditionally speaking, there are three of them – equity, debt and cash. However, to that, you can also add real estate, precious metals (gold, silver etc) and alternatives such as art, coins and other collectables.
Historically, it has been seen that the correlation between equities and bonds have been low and they don’t move in the same direction. During the bullish phases of the market, usually, the bond yields flatten and vice versa.
Here, during the bear phase of 2007-2008, while equity was down by 55%, debt funds were up by 15% or more thanks to a rapid fall in interest rates (which results in appreciation of bond prices and portfolio).
Thus by investing in different assets that are least correlated; the investor’s portfolio could minimize risks of overconcentration while also capitalizing on potential market opportunities - just like the above street vendor. However, over the long run, it also affects the return potential – as you will read further.
What’s the ideal asset allocation?
There is no such thing as an ideal allocation. It can be 100% equities, 50% equity and 50% debt or 100% debt. It all depends on the financial goals, risk tolerance, and investment horizon. Let’s take it one-by-one.
Goals could be long-term or short-term. Long-term goals are typically for retirement and providing for children’s higher education, while short-term goals could be saving for an international holiday or owning a gadget.
Asset allocation for a long-term goal is usually equity-oriented. As a thumb rule, any investment that is not required for at least five years could be ploughed into equity funds, while the rest could be invested in liquid or short-term funds. With debt investments, you cannot expect to beat inflation (get about 6% annually) but with equities where the potential is to earn around 11% (as of 2021), patient investors can create inflation-beating wealth over the long-term.
Usually, the risk tolerance of an individual is difficult to gauge unless he has experienced a bear market. However, know that being conservative can also delay or compromise your financial goals.
So, arrive at an asset allocation that suits your various financial goals and investment horizon.
What if the stock markets soar and the asset allocation gets tweaked. Let’s assume, you had an investment of Rs 1 crore – with 60% equity and 40% debt assets. Now a 20% rise in the stock market over the year, has increased the equity portion to 70% of the portfolio. Should you prune the exposure back to a 60% level?
There are essentially two ways in which asset allocation is managed. One is called the Strategic allocation, whereby the target allocations are maintained through periodic balancing. Here, an investor or her advisor will revisit the asset allocation in a year or so and prune exposures to bring it to the targeted level.
Sometimes, advisors also suggest tactical asset allocation to capitalize on short-term opportunities based on market valuations and macro fundamentals. Here too, the attempt is not to time the market but to incrementally plough investments into assets based on its relative lucrativeness.
Will asset allocation ever need a change?
Asset allocation is not set in stone and will change with a change in your goals. An earlier than expected retirement for instance could mean saving more or investing aggressively in equity to hit the target earlier. Similarly, a family life event could set a new goal which in turn could affect overall investment portfolio orientation.
Asset allocation matters more than stock or fund picking. By choosing an appropriate asset-allocation strategy and through its periodic rebalancing, you can balance the risk and return of your investment portfolio.