Asset Allocation
You would have seen some portfolios outperforming the rest. In the stock market as well, there is 90 percent of traders lose money and 10 percent of the people make money. Why is it so difficult? What do they do differently?
Why do we have only one Warren Buffet?
Why are there an only handful of billionaire investors, who have made their fortune by investing in the right assets?
What do you think they do differently than all the other investors?
We are going to answer all these questions in this blog. First and foremost, most successful investors' focus is not on return, but on risk management. Well, shocking, isn’t it? Yes, surprisingly, that is correct. They focus on mitigating the downside risk to earn a moderate return, but consistently.
One of the ways to reduce the overall portfolio risk is with the help of diversification. Now, diversification always comes at an additional cost i.e., reduced returns. Hence, Asset allocation becomes very critical as the decisions you take initially for your corpus will decide the fate of your portfolio in the future.
You never put all your eggs in one basket – You would have heard of this famous saying. What does it mean?
What is asset allocation?
Asset allocation in the most-simplest terms means distributing your money into different asset classes. For example, hypothetically, there are only two asset classes – Debt and Equity. The proportion of your portfolio that you decide to invest in Equity vs Debt, is the asset allocation strategy for your portfolio.
How do you decide the asset allocation?
Well, the most appropriate strategy to diversify into different asset classes simply depends on your style of investing, risk appetite, return profile, and liquidity requirement. The asset allocation strategy directly impacts the risk-return profile of your portfolio. For example, with additional allocation to equity markets, your risk increases, but also provides access to higher returns.
Why is the right asset allocation important?
There are numerous surveys, studies, and research papers submitted on this subject. Researchers always try to identify the reasons for success and attribute it to various factors such as asset allocation strategy, stock selection strategy, the timing of investment, etc. The major reason to understand, analyze, dissect and attribute the performance in the past to various factors is to then build a modern portfolio based on the most successful factor.
Such studies in the past have clearly shown that close to 3/4th of the overall portfolio return is attributable only to the asset allocation strategy whereas the balance of 25 percent success is attributed to the timing of the investment and security selection.
Why does asset allocation play an important role?
The economic activity across the globe depends on the changes in the business cycle, and so is the performance of the individual asset classes. It is the nature of the economy that time and again certain assets, industries, and sectors tend to outperform due to the change in long-term business cycles and the influence of change in economic activity.
The business cycle generally reflects the fluctuations of industries in an economy. This can be a critical factor to evaluate and predict the asset’s performance over a period. Any business cycle will have a period of stability, followed by extraordinary economic growth, followed by a slowdown, and maybe a recession to follow. The recession is typically followed by stability in prices at those lower levels and the cycle continues.
Such business cycles from peak to trough to peak are again reflected in the stock prices as well.
To give you a very easy example, in an early stage recovering economy, the stocks typically outperform other asset classes whereas, in times of recession, they are the worst performers. Hence, it becomes crucial to diversify across asset classes to make consistent returns and not wipe off your entire capital when times are bad. Diversification allows you to see the light at the end of the tunnel and helps you live for another day.
How does the right asset allocation affect your corpus in the long term?
Let us take a very simple example again of a person who has started working, at the age of 25 years, and plans to invest INR 50,000 per year. There are two options for him.
Play safe and Invest 70 percent in debt, 20 percent in gold, and 10 percent in provident fund
Take some risk (because he is young – risk-taking ability is high) and invest 45 percent in equity, 35 percent in debt, and balance equally in gold and provident fund.
The difference between the two options is huge. Option ‘a' gives him a CAGR of just under 9 percent, whereas option ‘b’ will provide him a CAGR of more than 18 percent. You may think that it is just a matter of 9 percent on INR 50,000 i.e. INR 4,500 for the entire year. It is not a big deal.
Well, that is not true at all!
How does this ~10 percent delta translate into actual money in the long run?
Over the next 20 years of investing INR 50,000 per year, option ‘b’ will grow to more than six times the value of option ‘a’. The benefits of compounding, in the long run, are substantially high and beyond the imagination of a human brain.
Now that we have agreed and understood that asset allocation is important and creates a huge gap in the end-state corpus, let us understand the different asset allocation strategies for your portfolio
What are the different asset allocation strategies?
Strategic Asset Allocation
It is the most basic and simple to use strategy. If your desired return is 10 percent from your portfolio and you know that historically, the stocks are averaging 12 percent return and bonds end up at 8 percent. The simple formula suggests that the asset allocation weight to stocks should be 50 percent.
Strategic asset allocation focuses more on the buy-and-hold strategy even if eventually because of future returns, the asset allocation weights have changed, you don’t take action.
Constant-weighting asset allocation
An extension to the Strategic Asset Allocation strategy where you continually rebalance your portfolio at regular intervals to bring it back to the original mix of different asset classes.
For example, the original weight was 50% of both assets (portfolio value: INR 1 lakh). After 12 months, the stocks gave a return of 20 percent, whereas the bonds gave a return of 8 percent. Here’s what you need to do.
Asset class
Start value
Original weights
Asset returns
End value
Revised weights
Rebalance
Equity
50,000
50%
20%
60,000
53%
-3,000
Debt
50,000
50%
8%
54,000
47%
3,000
1,00,000
1,14,000
There are multiple other ways to allocate weights to your portfolio to achieve the most optimum diversification. Depending on your portfolio management strategy, the asset allocation can be active to varying degrees of involvement.
You need to be aware that taking decisions in real life about your portfolio i.e. real money requires a great deal of focus, understanding, and expertise of the market as well as skills to use some of these tools for timing these movements.
Please consult a financial advisor before making any money management decision.