The equity market might seem like a sea of madness for new investors and old ones. The Sensex was down nearly 40% during COVID and, a year after, recovered all the losses.
However, after scaling 60,000 in early 2022, the Sensex again went downhill. As of 19 July, the Sensex is at 54,400 levels and is especially volatile as fears of recession and geo-political uncertainty sway the global economy.
In these erratic times, should you realign your asset allocation?
First, let’s understand asset allocation and the different ways of executing it.
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.
There are major three major asset classes – equity, debt and cash. In addition, some add real estate, precious metals (gold, silver etc.) and alternatives such as art and coins to the asset class mix.
While asset allocation is about investing across different asset classes, it is much more than the mere diversification of a portfolio. The basic premise is that combining assets that are not highly correlated can reduce the portfolio’s volatility and improve risk-adjusted return measures.
Types of asset allocation
Strategic asset allocation
In this, the investor arrives at an asset allocation mix based on the expected return from each asset class. It heavily relies on diversification as a measure to mitigate risk.
Since it is a buy-and-hold strategy, the investor does not sell or buy even if values shift, causing a drift in the original asset-allocation mix.
Constant-weighting asset allocation
Constant-weighting asset allocation differs from strategic asset allocation. For example, suppose that an investor had intended to keep 65% in equities and 35% in debt to achieve his financial goals.
If the asset allocation mix becomes 50:50, he will increase his investment into equities to restore the original blend. Usually, rebalancing is done when there is a deviation of 5% or more from the fundamental combination.
Tactical asset allocation
Some consider constant-weighting asset allocation to be rigid since whenever market opportunities come, investors are not able to capitalise on them. On the other hand, tactical asset allocations work on this demand.
For instance, you might have worked out an asset allocation of 70% equity and 30% debt. However, if you think the equity market will provide short-term opportunity, you temporarily let the equity mix go up to 80% without rebalancing. Then, when the short-term opportunity has run its course, you promptly bring it back to the original mix.
Tactical allocation can also be done within asset classes. For instance, if you think midcaps are attractive, you might temporarily increase the allocation to midcap against large caps. In a way, these strategies are momentum-based.
Dynamic asset allocation
Here you don’t get fixated with a percentage of allocation to each asset and take decisions dynamically based on the market situation. So, the asset allocation mix changes depending on the market conditions.
Counter-cyclical (contra) strategy is widespread, whereby equity exposure increases when valuations are low and vice versa using benchmarks such as P/Es and P/Bs, among others.
What should investors do?
Most retail investors can work with constant-weighting asset allocation to achieve their respective financial goals. First, it enforces discipline in investing. You tend to rationalise your portfolio effectively and manage risk by regularly rebalancing.
If you stick to it irrespective of market movements, you will unlikely make wrong investment decisions out of greed and fear.
Tactical asset allocation, in contrast, calls for considerable investment expertise and market timing. So venture into it only if you have a good track record of capitalising on short-term market opportunities. And remember to play it safe.
Dynamic asset allocation is best left to fund managers. It is suitable only for seasoned investors who are well-versed with market trends and have successfully adopted them across market cycles.
A comparison – Constant-weighed and dynamic
A portfolio adopting constant-weighted asset allocation tends to outperform in a bull market but is also more volatile than dynamic asset allocation funds in volatile/bear markets. Interestingly, over the long term, hybrid equity-oriented funds (constant-weighted) have smartly outperformed dynamic asset allocation funds.
Don’t worry about short-term volatility in the stock markets. If you stick to your asset allocation irrespective of market movements, you are far less likely to go wrong on investment decisions.