Ever wondered why vegetable vendors have a variety of items on their carts? To give the buyer a choice and also to spread his own portfolio across vegetables. So while one customer may want only staple vegetables, such as onions and potatoes, and the other only seasonal vegetables, his “returns” would be balanced since he has a good mix.
Asset allocation in practice isn’t much different from what a vegetable vendor does. It advocates the practice of investing money systematically across a basket of assets to ensure if one doesn’t work, the other balances out the overall portfolio.
Why is it important?
There are primarily two reasons—to achieve a financial goal and to minimize risk.
Today, most wealth managers are using asset allocation as a primary approach to investments. Says Atul Singh, managing director and head, global wealth and investment management, India, DSP Merrill Lynch Ltd, “We propose a detailed risk profiling and a target allocation for all clients.”
Also see | Balancing Act (PDF)
Achieving a financial goal: Most of us invest with the aim of achieving one or more financial objectives, which can be done with a higher degree of certainty by following a defined asset allocation.
Let’s say that out of your many goals, one is to get your daughter married after eight years and it’s likely to cost you around Rs12 lakh.
Start today by investing around Rs5 lakh in equities for six years. Assuming a compunded annual growth rate (CAGR) of 15% for equity investments, your corpus will grow close to Rs11.56 lakh by the end of the sixth year. At this time, you can transfer this money to a less risky investment option for two years to ensure that the capital aimed at is available at the end of eighth year when you actually need it.
Allocating entirely to debt at the beginning itself would have meant that you fall short of achieving the desired corpus. For instance, if the above mentioned Rs5 lakh is invested in a 10-year government bond giving 6.53%, it would give only Rs8.3 lakh at the end of the eighth year. Hence, one has to consider a basket of assets to balance risk and return. The above allocation to equity forms only a part of your portfolio and not the entire portfolio allocation.
Minimizing risk: It is risky to have all your money invested in one asset class. Let’s consider equity, albeit over a longer period, say, 10 years, equities have the potential to deliver 10-15% CAGR; in shorter periods, returns can be volatile. Say you had your entire surplus of Rs10 lakh invested in equity in 2008, with the market crash you would have lost around 52% in one year (based on the Nifty returns between 1 January 2008 and 31 December 2008) bringing your investment down by Rs5,18,395. Now let’s imagine that you had a diversified portfolio: 50% (Rs5 lakh) in equities, 30% (Rs3 lakh) in 10-year government bonds giving 6.53%, 10% (Rs1 lakh) in gold, which gave 5.77% during the one-year period and 10% (Rs1 lakh) in your savings account earning 3.5% at that time. In the second scenario, you would have lost around 23% or Rs2,30,343.
So clearly the asset allocation approach helps limits losses when returns are falling. Since it is impossible to know in advance how the market will move, it’s prudent to have your surplus spread across different assets and balance risk and return.
How do I go about it?
Finding the right asset allocation depends on personal choices and circumstances and can’t be limited to a formula; it has to be a dynamic exercise and should be revisited frequently. Here are some of the factors that can help you plan your asset allocation.
Goal timelines are important: Start by evaluating your financial objectives for the next 10-20 years. Mark each objective in terms of priority and quantify them for the money required.
For goals that are at least 10 years away, say, your child’s education, you can take higher exposure to riskier assets. For example, if you were invested in the Nifty index from 2000 to 2010, your money would have grown at a CAGR of around 15.27%.
Says Amar Pandit, chief executive officer, My Financial Advisor, a financial planning firm: “We encourage goal-oriented asset allocation. The idea is to try matching the right kind of assets to every goal; each goal can have its own asset allocation.”
For goals that are a year or two away—say, buying a car or going on a foreign holiday—it makes sense to preserve capital and go for debt investment options. Taking too much exposure to equity in the short term may be extremely risky. The Nifty’s 52% correction in 2008 is a case in point.
Risk profiling: The level of risk you are willing to take is a crucial factor. Your willingness to accept a level of risk doesn’t mean its appropriate for you. For example, if bulk of your financial objectives mature in two years, including paying for your child’s higher education, relying on only equity may not be suitable as the period is too short to expect equities to deliver the desired returns; you’d rather look towards debt investment options.
Aggressive investors look for growth in value and if you are conservative you will lean towards capital preservation and regular income. You don’t have to define your allocation in the two extremes; mostly you would set your limits somewhere in between.
The right asset: If you have the above two factors sorted out, the choice of asset would automatically fall into place.
Typically, equities are considered long-term assets and fixed-income products are used for earning regular income. Says Pandit, “When we plan for a client, we usually assume 12% per annum returns from equities and 6-7% post-tax returns from debt investments. Any goal above five years qualifies for an allocation to equities and goals with shorter time horizons are better catered to by debt.”
Mistakes you shouldn’t commit
Don’t sleep over portfolio: Building the portfolio is only half the job done, it’s just as important to rebalance at appropriate intervals. You can define these intervals by time, change in value or when you are closer to achieving an objective. “Rebalancing is triggered by the change in asset values, but ultimately any addition or reduction is done based on the market view at the time,” says Rajmohan Krishnan, senior vice-president, Kotak Mahindra Bank Ltd.
But do not base rebalancing only on market movement. Also, don’t be too rigid and worry too much about 5-10% shifts.
Says Suresh Sadagopan, principal financial planner at Ladder7 Financial Advisories, “Sometimes there is resistance to make shifts from asset classes, especially when one is doing well. But, for the purpose of asset allocation, we don’t try to micro manage portfolios, any changes and rebalancing has to be looked at in the context of long-term goals.”
This means that if the overall portfolio allocation is in line with the goals you outlined then don’t worry about small percentage shifts in asset values or allocation over short periods of time.
“Review the portfolio every three months but any major rebalancing can be done annually,” says Sadagopan. At the time of selling/buying products for rebalancing, remember to consider taxation and fee outgo.
Don’t chase returns: For rebalancing look at the overall portfolio, don’t only follow returns. Says Singh, “Clients often have a tendency to chase returns and ask for the product that delivers the best returns, not considering its risk profile.”
To benefit from a suitable asset allocation, one has to show discipline in following it through market cycles over a period of time.
Asset allocation will help you balance your portfolio returns and manage risks better so that you achieve your financial goals. At the outset it may seem like a lot of work, but after the initial effort, the strategy works for you rather than you working on the strategy.
Graphic by Yogesh Kumar/Mint