Asset Allocation (AA) sounds sophisticated, no? It assumes you have an asset to allocate and gives a boost to your ego, eh! Looks like a smart and sexy word for a thing as drab and dreary as planning your personal finance. And AA also gives you a feeling that you are holding some aces (AA) rolled up in your sleeves.
But, despite being a sophisticated term, it actually is a very simple and boring way of managing your investments. Especially when you compare it with timing the markets or with picking up multibagger stocks. Both timing the market and picking up stocks sets your heart racing. With asset allocation, your investments are on an auto pilot.
What is asset allocation? It is the method of investing based on the study by Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower in 1991. They found that over 91% of long-term portfolio performance is derived from the decisions made regarding asset allocation, and not market timing or security selection. This traditional buy and hold method is boring – but it works.
Asset allocation is the percentage distribution of your money into equity, debt and liquid instruments. Equity, as you know, gives the highest growth but comes with the highest risk. Debt instruments are more or less guaranteed but give you a lesser return. Liquid money is your money in your savings account.
Let’s start with the thumb rule of AA. Your allocation to debt should be equal to your age. And as you age, the percentage in debt should increase too. In other words, your investments in equity should be (100- your age).
But AA should be much more dynamic than the above thumb rule. I feel that it should depend on your age and your risk appetite. Guys at 20-25 years of age may want to invest everything into equities and I think that is the right strategy.
And before you set off to do some Asset Allocation for yourself, I would like you to ask the following questions to yourself:
1. What is your risk appetite?
2. What are your financial goals?
3. When do you need the money?
The answer to the first question is a choice between a conservative and an aggressive investor. If you are conservative you allocate a greater percentage into debt and bonds. If you are aggressive your allocation has less debt and bond and more mid, small and large cap stock. Aggressive allocations will probably have a better rate of return over time than going conservative, but will be the most volatile, meaning your values will fluctuate up and down more. In other words it’s a trade off between lower returns and the large fluctuations.
The answer to the second and the third question should also be a factor in your asset allocation decision. For example if you have ambitious financial goals, it would be a good idea to have a greater allocation for stocks. And if you need the money in a short period of time, you wouldn’t like to lock it up in illiquid investments.
And if you love ready made formulas, here’s some from allocation strategies: To make it simple, we have taken out the percentage that should be in your saving account ( liquid instrument)
• Older investor (Conservative) : 30% equity; 70% debt
• Older investor (Aggressive) : 50% equity; 50% debt
• Young investor (Conservative) : 80% equity; 20% debt
• Young investor (Aggressive) : 95% equity; 5% debt
Rebalance Your Portfolio: Even though asset allocation is a simple way of putting your investments on auto pilot, the success of this strategy lies in monitoring it regularly. Look, even when we have advanced technology to run a supersonic jet, we need pilots to monitor the dashboard and take corrective action. Similarly, we need to rebalance the portfolio regularly. What does this rebalancing mean?
Let’s say your investment in stocks/equity go up 5 percent, while your investments in bonds decline by 1 percent. If you have holdings in both areas, the percentage of your portfolio that’s in stocks has grown a bit, and the debt portion has shrunk a little. Over time, this process can really change the face of your portfolio — especially if you continue to reinvest your earnings without ever rebalancing.
So while you started with a 70% in stocks and 30% in debt/bonds, after a few months, you can end up at 80% stocks and 20% debt/bonds, as the stocks have been growing much faster than the bonds.
To be more lucid, let’s take a hypothetical example of a starting portfolio of Rs 10 lacs. You have invested Rs 7 lacs in stocks (70%) and the balance Rs 3 lacs in bonds. As your stocks grow faster to Rs 9.75 lacs and the bonds grow to Rs 3.25 lacs, your asset allocation is now 9.75/13 = 75% stocks and 3.25/13 = 25% bonds. What do you do now?
Actually this is the most difficult part. While your stocks are doing well, you have to take out your investments in stocks and put them into debt. To make it 70-30 again, Rs 65000 out of stocks and invest them into bonds. So the balance stocks portfolio is Rs 9.1 lacs which amount to 70% of Rs 13 lacs. So you are honouring your asset allocation decision again. But as I said, this is easier said than done.
But look at the benefits again. Moreover by honouring your asset allocation decision, you are automatically selling when the stocks are on a high and buying when the going is tough. This is what the experts really do. By being a contrarian investor, you are not letting in fear and greed guide your decision. And you are smarter than the majority!
Adjust Your Portfolio as You Near Retirement: As you get older and closer to retirement, it’s obviously important to have enough money in less risky, more predictable investments. So, rebalancing your portfolio with age is also a sensible decision.
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Indeed a very insight on AA, i personally spend lot of efforts in AA. In my AA am also considering Large cap, mid cap and small cap. Any thoughts on in this area?
Cheers
Marshal
@Marshal. You’re much ahead on the learning curve as you are classifying within the stocks category. Again, we need to have an eye on our own risk appetite. Further, it is important to understand the fundamentals, the performance of the stocks first rather than having a large/middle/small cap view for your asset allocations (In my view).
How are you allocating to large/mid/small cap stocks?
is any thumb rule to identify the risk appetite of an individual?
@ Guresh No thumb rule that I know of. But it’s actually common sense and we all know whether we are risk averse or risk takers.
It helps to answer a few questions to become aware of your risk appetite.
I strongly believe that one most have allocation between American stocks v/s Indian stocks (one with indian broker another one with american broker) for a variety of reasons. Secondly, diverisification comes from diverse industries but not related industries and companies within those industries that have better variety at reasonable margins. Thirdly for most investors with reasonable timeline, are risk takers who need scale between risk v/s risk free assets that need to be balanced from time to time. So a young investor might want more risky assets, but for the art of “portfolio navigation” he needs combination that has some material weight into risk free products like 20% or 30% in FD/G-sec funds.
Ranjan,
Again a good one….you talk sense. Though I believe that frequent pooling out from equity returns and investing the takeout in real estate can work wonders. This should help because Land is something which is not growing and automatically you are adjusting your portfolio. Still like to open a pandora box discussions on it…!
@ranjan,
am 30yrs old hence 70% equity(MF+direct equities+index), 25% debt(PPF+FD+EPF+Saving a/c) and 5% gold ETF.
am not sure what should be done with respect to large/mid/small cap, but if i look my current portfolio then AA is 70%/29%/1% (large/mid/small)…it was not done deliberately but this is what is today, but i want some direction here
any thoughts here?
Hi Ranjan,
Nice article and a good read. To do this one needs a lot of discipline and not be swayed by the emotion of greed and fear like you mentioned. Only a very few people are able to be consistent with their AA. Would you agree? I feel the majority of the people need a good and disciplined financial advisors to keep their emotions in check.
Thanks…
Neil
(www.ppfas.com)
Hi Ranjan,
Nice article and a good read. To do this one needs a lot of discipline and not be swayed by the emotion of greed and fear like you mentioned. Only a very few people are able to be consistent with their AA. Would you agree? I feel the majority of the people need a good and disciplined financial advisors to keep their emotions in check.