ABC of asset allocation: Balance between equity, debt and realty is a must

2020 has been a roller coaster year for investors, with lows in March 2020 and an all-time high by the end of 2020, driven by record inflows from foreign institutional investors (FIIs), highest ever quarterly profits (Q2) reported by Nifty 50 companies from doomsday that has no equivalent in the history to one of the fastest V shape recoveries of all time. The rally in markets has been broad-based, started with blue chips, and smartly caught up by mid-caps and small caps.

Presently Indian markets are at an all-time high, and the investors are confused to take their next step. In our opinion, if an investor is already invested then this is the ideal time to review the portfolio. If your funds are doing well, you may continue, else you may need to exit, redeem, or consolidate the portfolio. If there is substantial underperformance viz-a-viz category as well as a benchmark for a couple of quarters, the fund needs review.

For fresh investments, stagger them in 12 to 18 months either through SIP (Systematic Investment Plan) or STP (Systematic Transfer Plan) for averaging out the investments at different market levels instead of lumpsum in one go.

Also, the recent volatility in the market has sensitized advisors and clients on the importance of asset allocation in investment portfolios. Asset allocation has been the most talked-about buzzword recently, but in my opinion, most of the investors still do not understand the concept in true spirit. For most investors, it is just allocation of funds in various asset classes’ viz., debt, equity, real estate, bullion, etc.

Let’s try to understand the importance of asset allocation in simple terms. Asset allocation is an investment portfolio technique that aims to balance risk by dividing assets among major categories such as cash, bonds, stocks, real estate, and derivatives. Each asset class has different levels of return and risk, so each will behave differently over time. The objective of asset allocation is to minimise volatility and maximise returns. 

Asset allocation will be different for every investor. It is arrived at based on different factors—investor’s age, lifestyle, goals, and risk-taking appetite among others.

The importance of asset allocation needs to be understood in 3 forms:

• Importance of asset allocation in portfolio construction: Asset allocation is important because it has a major impact on whether you will meet your financial goals or not. If you don’t include enough risk in your portfolio, your investments may not earn enough returns to meet your goals. For example, if you are saving for long-term goals, such as retirement or higher education of your child, you must include adequate stocks or equity mutual funds in your portfolio. However, if your portfolio consists of too much equity, it can be highly risky. In such cases, if the market observes a sharp correction when you are closer to your goal, it can prove fatal. A portfolio heavily weighted in stocks or equity mutual funds, for instance, would be inappropriate for a short-term goal, such as saving for a family’s summer vacation or buying a car.

• Regular monitoring and re-balancing: Most of the time we forget that the change in market dynamics or volatility also changes the risk appetite of investors. So the asset allocation strategy devised at the time of constructing the portfolio may not hold true if the market witnesses huge volatility. Thus with the change in market valuations, the allocation of investment in various asset class also need to be re-balanced. Asset allocation aims to generate better risk-adjusted returns. For example, if the valuation of the equities seems cheap, one should increase allocation to equities so when the equity market goes up, the portfolio generates better returns.

The most common reason for changing your asset allocation is the change in your time horizon. In other words, as you get closer to your investment goal, you should change your asset allocation. For example, investors investing for retirement should move to debt funds, bonds, and cash equivalents avenues as they get closer to retirement age. You may also need to change your asset allocation if there is a change in your risk tolerance, financial situation, or the financial goal itself.

• Minimising risk in the portfolio: Asset allocation helps to reduce risk in the portfolio. Whenever the asset class becomes expensive for example, if the equity market has become expensive or overvalued, one should change the asset allocation in the portfolio by reducing exposure to equities. There are many tools to understand the valuation of equities for instance PE Ratio, Market Cap to GDP Ratio, etc.

• Adequate Liquidity: Liquidity is one of the vital factors while making an investment decision as some investments have a lock-in period and can’t be redeemed within that period. For example, if you are investing in a public provident fund (PPF) account or equity-linked saving scheme (ELSS), mutual fund and are in need of money in the next 1 year, then they aren’t the right investments avenues for you, no matter how good these investments are. Thus prudent asset allocation will make sure that you have sufficient liquidity to pay for your financial goals as and when required. We observed that many investors, who had over-exposure in equities before the pandemic, were taken aback when the equity market crashed. The valuation of their investment was so less that they were not worth selling at that time to generate cash.

Defining an optimal asset allocation is not as easy as it might seem to you, because you need to take into account, host of factors to reap the benefits of prudent asset allocation. But once prudent asset allocation is in place, you can rest assured that you will earn an adequate return, minimise risk and taxes, have sufficient liquidity, and even achieve your financial goals.

(The writer is the managing director of Midas Finserve Pvt. Ltd. Views expressed are personal)