Asset Allocation

Asset Allocation

Asset Allocation

What is Asset allocation?

The five-year Bull Run from 2003 to 2008 had made concepts like debt, cash, asset allocation and financial planning quite unfashionable. The only investment destination one could think of was equity, thanks to the soaring stocks markets. The steep fall in equity market since January 2008 has left many equity investors licking wounds, leaving virtually no place to hide. Bull market or bear market, there is never a time to abandon asset allocation. Times have changed and so has the thinking. It is essential to recognize the power of asset allocation all times, including tough times. Investors are now giving more relevance to asset allocation and planning of investments keeping in mind the long-term financial goals.

Asset allocation refers to the process of allocating your investments between different asset classes. Asset allocation means diversifying your money among different types of investment categories, such as stocks, bonds, gold, property and cash. The goal is to help reduce risk and optimize returns. The goal of asset allocation is to create an optimum mix of asset classes that have the potential to appreciate while meeting your risk tolerance level and financial goals.

Most investors prefer equity for their core portfolio, adding bonds to reduce volatility and downside risk. With low real returns in debt instruments and rising inflation levels, there is a danger that investors may not meet some of their long-term financial goals. Goals for an individual could be meeting child’s college education five years hence or buying a house ten years from now. Different asset categories behave differently in terms of risk – return profile. Stocks, for instance, offer potential for both growth and income, while fixed income instruments offer safety of capital and steady income. The benefits of different asset categories can be combined into a portfolio with a level of risk one finds acceptable. Establishing a well-diversified portfolio may allow you to avoid the risks associated with putting all your eggs in one basket.

What is the right asset allocation?

There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. Your selection of individual securities is secondary to the way you allocate your investment in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results.

Asset allocation decisions depend on the following factors:

  • Time frame
  • Risk tolerance
  • Personal circumstances
  • Liquidity needs
  • Tax consideration

Depending on your age, lifestyle and family commitments, your financial goals will vary. You need to define your financial goals like buying a house, marriage of son/ daughter, paying for your children’s education or retirement. Besides defining your objectives, you also need to consider the amount of risk you can tolerate.

For example, when you retire, you might want to earn steady income from bonds / deposits, financial advisor might recommend say 100% debt portfolio. On the other hand, for young investor, if he does not need money for 20 years and is comfortable with the volatility in the stock market, a financial advisor might recommend an asset allocation of 80% in stocks.

Once the asset allocation is done, it does not mean that you just set it and forget it. Reviewing your portfolio regularly with your financial advisor to monitor and rebalance your asset allocation can help make sure you stay on track to meet your goals.

Asset Rebalancing


The Process of rearranging assets to bring allocations to predetermined original level as per Financial Plan.
Over time some of your investments may become out of alignment with your investment goals. You’ll find that some of your investments will grow faster than others. By rebalancing, you’ll ensure that your portfolio does not overemphasize one or more asset categories, and you’ll return your portfolio to a comfortable level of risk.

Needless to say Asset Rebalancing forms part and parcel of every Financial Plan

While a lot has been written about asset allocation and about the virtues of having the correct asset mix, very little of an investor’s attention goes to asset rebalancing. Also as part of reviewing your portfolio it is necessary to periodically check your portfolio’s asset allocation and ensure it’s still in line with your goals.

Let us explain in detail with an example:

Mr. .Manish owns a 200 lakh portfolio as on June 2007 with 50:50 in debt and equity. He is has five years to retirement and needs to build on his debt portfolio . His aim is to maintain 10 lakhs in equity and all excess funds in debt. He rebalances his portfolio every six months. In Dec 2007 he checks valuations of his portfolio to find that during the market boom of 2007 his equity portfolio recorded a gain of 40%. Total portfolio value is Rs.24.6 lakhs in Dec 2007. He sells Rs. 4 lakhs worth of shares and invests the same in debt. Now his portfolio in equity is valued at 10 lakhs again while the debt portfolio is at Rs 1440000 (1040000+400000) accounting for a 8 % interest on debt.

Next Rebalancing is scheduled for June 2008. Equity portfolio has corrected by 30% to 7 lakh, while debt portfolio stands at 1500000. Mr. Suresh switches back 1500000 into equities. He now holds 12 lakhs in debt plus 10 lakhs in equity. His annual return is 10 % despite market correction.

Mr. Hitesh too holds 10 lakhs in equity and 10 lakhs in debt as on June 2007. He does not rebalance his portfolio. By December 2007 he too sees a 40% jump in equity portfolio but does nothing. His Portfolio value in June 2008 would be 20.6 lakh – a mere return of 3%. The example above covers a very small period of time i.e. one year .Also it gives an example of an investor wanting a fixed sum in equities. You could devise your own plan and criteria and there are many ways of doing it.

Some advisors recommend rebalancing only when the relative weight of an asset class increases or decreases more than a certain percentage that you’ve identified in advance. The advantage of this method is that your investments tell you when to rebalance (as against a timetable).

Over long periods of time asset rebalancing has proven to substantially contribute to better average return and hence to the success of your financial plan. The biggest advantage of this exercise is that it helps you sell overvalued assets and buy undervalued ones.

Assets mostly owned by investors are Cash/Debt, Equities, Bullion, Real Estate and Alternative investments like Art/ Private Equity etc. Except for the super HNI, lay investors would typically hold a portfolio of debt ,equity, and real estate. Rebalancing can be done with almost any asset class, depending on its weightage in an investors portfolio . However some assets are easier to transact in as compared to other. For example bullion is mostly held in the form of jewelry and sentiment value does not allow us take economical decisions when it comes to these investments. Real estate too has it drawbacks in terms of limited liquidity, difficulty in part selling (Can’t sell half a flat can u?) and high transaction costs. Also most real estate held by the middle income and upper middle income investors will be for self consumption. Equities debt and cash become the best choices for an asset rebalancing exercise. Because Equities are prone to irrational ups as well as down, a mere mechanical asset rebalancing between the three asset classes can give superior returns.

Points to note :

Taxes and Transaction costs can cut the extra returns accruing from asset rebalancing. You must weigh the impact of both before planning on a asset rebalancing schedule.

This process has to be mechanical with no scope for opinion or emotional decisions. It also requires a certain degree of discipline to ensure that rebalancing takes place on schedule/change in weightage.

How often one rebalance should: As an investor a half yearly/annual rebalancing if time based adequate. Where asset rebalancing is done based on change in weightage, the frequency should be kept at minimum by simply keeping the cut off levels on the higher side. Frequent rebalancing does not aid in increasing long term returns.