What is asset allocation? Why is it crucial?
The dictum ‘do not put all your eggs in one basket’, holds true for your financial portfolio too. Asset allocation is the practice of splitting your wealth among multiple asset classes. The practice of dividing your financial assets portfolio among multiple asset classes, each of which has unique return and risk characteristics can help it weather multiple market cycles successfully.
Take the ‘year which must not be named’, 2020. If an investor had his entire financial assets portfolio concentrated in equities in January 2020, he would have beamed as the Sensex rallied to historically high levels in mid-January, only to experience terrible bouts of crippling anxiety when the equity markets globally crashed by nearly 30%. This dread would have been nauseating if he was relying on liquidating a part of his portfolio for some imminent expense. He would have no other way out but to sell-off a fraction of his portfolio at a significantly low price. If he instead had a diverse portfolio composed of asset classes like equity, fixed income instruments, gold and cash which do not move in tandem with each other, he would have found navigating the first two quarters of 2020 a much easier experience.
But is diversification the only benefit of asset allocation? No.
Every individual, depending on his or her age, current financial position and appetite for financial risk has a unique ratio of equity and fixed income instruments that they should hold in their portfolio. This is known as the individual’s target asset allocation. Sticking to your target asset allocation does help you maintain a diversified portfolio. But ensuring that you reset your portfolio to your target asset allocation any time it veers away from the target, makes you privy to the holy grail of consistent wealth creation, which is (drumroll), to Buy Low & Sell High. If you could always find ways to buy assets when they are valued low and sell them when they are flying high, the road to financial freedom is yours to take.
But, here’s the catch. How low is the lowest and how high is the highest? How do you decide when to buy and when to sell? A certain Mr. Bruce Lee once said that “Simplicity is the key to brilliance”. This tenet holds true not only in the realm of martial arts, but also in the world of wealth creation.
Enter ‘target asset allocation’. Let’s assume X’s ideal asset allocation is a 50:50 equity-debt mix. Let’s also say that X has an overall financial asset base of Rs.20 lakhs. We want to split this asset in the 50:50 ratio and rebalance each quarter in case the mix has skewed in either direction. We start by investing Rs.10 lakhs in equity and the remaining Rs.10 lakhs in debt. We are in June now and will rebalance this portfolio 3 months from now, in September. Let’s also assume that we have a bull run between June and September and the markets soar.
All figures indicated below are to illustrate a concept and are not indicative of returns. From June to September, the equity portfolio increases from Rs.10 lakhs to Rs.12 lakhs. The debt portfolio increases to Rs.10.5 lakhs. Quite obviously, X’s portfolio is not in the 50:50 balance. The total value of the portfolio is Rs.22.50 lakhs and equity is nearly 53% of the portfolio, which is 3% more than where it should be. To bring the portfolio back to our recommended 50:50 balance, we move Rs.75,000 from equity and reinvest in debt. Equity would now stand at Rs.11.25 lakhs and so would debt. The portfolio is now in balanced.
Now, let’s assume we go through a bear market from September to December. The stock market plunges and the equity portfolio drops from Rs.11.25 lakhs to Rs.9.25 lakhs. Debt portfolio moves from Rs.11.25 lakhs to Rs.11.75 lakhs. Total value of the portfolio is Rs. 21 lakhs and the portfolio is imbalanced. Equity forms 41% of the portfolio and debt 59%. To rebalance, X must sell Rs.1.25 lakhs worth of debt and reinvest in equity, so both asset classes stand at Rs.10.5 lakhs.
Notice that in the process of moving money from equity to debt (in a bull market) and from debt to equity (in a bear market), we are buying low and selling high. We sold when the markets were high, thereby booking profits, and bought when the markets were low, thereby buying value.
In this process, we were guided by two principles. One, target asset allocation of 50:50, and two, discipline to rebalance each quarter. Once we had pegged these two parameters, we achieved buy-low and sell-high.
What we didn’t achieve was buy when the price was the lowest or sell when the price was the highest. However, if we knew that answer, we would all be making money hand over fist. The fact is that no one knows when the high is the highest and low is the lowest. The good news is that you do not have to know that. Sticking to your target asset allocation will not only help you consistently generate returns better than the average investor population but will also give you a compass to guide you through the choppy waters of greed and fear financial markets subject you to.
Aparna M
Financial Advisor
PeakAlpha Investments