Asset Allocation is always misunderstood by investment community.
Let me ask you, what is your list of priority while investing.
The priority starts and ends with the asset’s return like equity, Gold, Real estate, etc., or investment vehicle like mutual funds, insurance, etc.
The premise of investing itself is wrong, and it should include much more than asset return.
Ideally, The investment journey should start with Goal setting, followed by asset allocation, portfolio construction, and preformation evaluation.
In this blog, I will dive into details of one of many aspects: ASSET ALLOCATION.
What is an Asset and Asset allocation?
Physical or financial investment, which one monetize for future money needs, would qualify as assets.
It can be physical like real estate, Bullion, precious metals, and so on. Or Financial like Bank FIXED DEPOSITS, POST OFFICE SCHEMES, Shares, Mutual funds, Debentures, and more.
Remember those investments or assets you are not planning to monetize (sell) in the future; you need not consider assets. For example, Investors should not consider a house as investments if you do not plan to sell it—the same for gold jewelry.
According to your financial goals, the method or strategy to invest in various asset classes in varying proportions is termed asset allocation.
Goals ten to 15 years away will have an aggressive portfolio with riskier assets in higher proportions. For financial needs in less, the three years may have a conservative portfolio with low volatility investment in higher ratios.
Asset allocation can help in reducing the volatility of the portfolio and help in optimizing the return. Diversification in various asset classes having low or negative correlation help in proper asset allocation.
Benefits of Asset Allocation
Proper asset allocations contribute your 90% of portfolio return.
There are multiple befits of proper asset allocation.
We all agree that all investments will have volatility built-in. Risk and reward are directly proportional; the higher the risk higher the return expectation.
Therefore, it is essential to hedge our risk by investing in multiple asset classes. Proper asset allocation can diversify the investment portfolio in a structured manner, thus diversifying the portfolio and reducing the risk.
Various asset classes perform to varying degrees at a different point in time. Doing proper asset allocation, i.e., investing in multiple assets, can give an optimal return at various times.
It is doubtful that all the asset classes will perform or underperform at a single point in time. A proper asset allocation will help design a portfolio of assets with a low or negative correlation between various asset classes.
For example, Equity and Gold investment has a low correlation, implying that when equity investment is performing well, the gold investment will not and vice versa. Diversifying helps in optimizing the portfolio return at all points in time.
Once an investor has decided on the asset allocation, it reduces a lot of time, effort, and expenses.
TIME & EFFORT
If you know how much one has to invest in an asset class, it reduces our time as we need not research and explore options to invest and how much to invest in reducing our effort.
Your dependence on any advisor or platform to guide you on various investment decisions will also reduce expenses.
It will have a multiplier effect on our wealth creations as the reduction in expenses will create additional wealth for you in the future.
Diversifying into multi assets reduces portfolio volatility and thus reduces risk.
Diversification will also help you in reducing a lot of your emotional exhaustion. Take the example of two portfolios.
Portfolio one is an example of proper asset allocation.
Thus reducing the volatility but delivering the desired results.
How to do Proper Asset Allocation?
There are multiple ways advocated by various financial planners to approach the asset allocation game.
Let me discuss some of them, including my recommendation.
Thumb Rule – (100-current age)
These are the most simplified way to invest in various asset classes. There are multiple variants too.
The method advocate that one should invest in Equity equivalent to 100 – your current age.
For example, suppose your current age is 30, so you should have 70% (100-30) of your investment resource in equity investment.
With changing lifestyle and individual requirements and life expectancy, one can take more than 100 as a benchmark like 110 or 120.
This rule will help in higher wealth creation because of higher allocation into equity and higher expected return from the portfolio.
With rising inflation and life expectancy, one should look for a higher corpus post-retirement and have aggressive investment and portfolio construction.
One can also look at Life expectancy – the current age for equity allocation for optimizing portfolio return.
Your current Investment Portfolio
One should be mindful of not spreading too thin in multiple asset classes.
The number of asset classes to have in one portfolio should be incongruent with the current asset size.
Suppose you are a beginner and young stick with two asset classes. For example, equity and debt. Whereas if you are middle-aged and have an investment journey of 5 to 10 years, look into other asset classes and vehicles.
The more number of asset classes or instruments you have, the more difficult it would be to monitor and do course correction.
The premise of asset allocation is to reduce volatility in the portfolio and optimize the return. To do that, we need to select the investments which have a low correlation with one another.
In simple terms, it means if we have an investment in two asset classes, say Equity and Debt.
Ideally, when equity investment performs well, the debt will not go up to the expectation. So when equity investment does not perform well, the debt will do the job, thus compensating for other asset class underperformance.
The correlation values between various asset classes will determine the performance of one investment against the other. A low correlation between two asset classes will indicate that one asset class’s performance is the opposite of others and so on.
Active Vs. Passive investment
Active investments are those vehicles where the fund manager actively participates in selecting the investment securities or managing the funds.
The history shows that these managed funds have delivered superior returns, especially in mutual fund space over passive investments. The cost or expense of these funds is higher than the passive funds.
A market where there is information asymmetry and not mature enough active funds deliver superior retunes.
Passive investments are opposite to active investments and perform well in mature markets. In INDIA, off late passive funds have started delivering well due to its cost advantage and portfolio construction.
Developed market like the USA and Europe, passive investment dominates the investment space.
Your portfolio is small and beginner, start with passive investments like index funds or Exchange Traded Funds (ETF). These mimic the investment performance of the broader market (benchmark).
As the portfolio grows, look for other complicated and costly products.
I would suggest one should do asset allocation according to the respective goals identified for the future.
Bucket your goals into three categories.
- Short term – Any financial goals which can come up in coming in next – 3 Months to 3 Years
- Medium-term – Goals expected in next 4-7 Years
- Long term – Goals planned for seven years and above.
So once you have your goal bucket ready, do the asset allocation like this.
- Short Term Goals – Bank Fixed deposits / Debt Mutual funds (No exit load period)
- Medium-term Goals – Invest in Equity & Debt in 60:40 ratio
- Long term Goals – Have 70:20:10 in Equity, Debt & Gold or Alternative investments
These asset allocations will give you risk-adjusted and tax-efficient returns.
The Execution Plan
The next logical step is to plan for the execution of the plan. The investor should choose cost-effective and easy-to-operating platforms and vehicles for investment and monitoring.
Core & Strategic Allocation
Your 70-80 percent of investment should be the CORE portfolio. The core portfolio should not be subject to the market’s timing or geopolitical changes occurring in the country. Individuals’ goals will help in creating a customer core portfolio.
The investments should be in passive funds due to the lower volatility as well as cost advantage.
20-30 percent of the portfolio should be strategic, comprising investment in active funds and ready for any opportunities arising due to unforeseen events in the investment scenario.
Asset and Vehicle
The choices of assets and vehicles should be a function of expenses related to the investment and ease of operations.
We need to remember that there is no use in investment if we cannot get our money back when we require it.
Choose those assets and vehicles which are well regulated and having broader holdings.
This way, you will have mental comfort and emotional peace.
In a particular asset class, there are various layers of investment options.
Like in equity, one has Large, Mid & Small-cap funds and stocks. Debt investments will have short term, long term corporate debt, Government debt, and so on.
My recommendation is to start with low cost and less volatile segments in a particular asset class and move to other elements with your maturity and volume.
Review & Rebalance
There has to be a regular review of your portfolio. My advice is one should do once in a year review of the portfolio.
Events like addition or subtraction of family members or any Geopolitical
changes need immediate attention to review once’s portfolio.
The changes in asset allocation have to be done on an individual Goal level as it is easy to monitor and do course correction. Customers should do Asset reallocation if any one asset class allocation has increased due to good preformation or vice versa, then the investor should do reallocation.
Tax implications and exit loads have to be understood before rebalancing the portfolio.
In the case of accumulated corpus rebalancing, one needs to take care of taxation.
The equity investment will have long term capital gains kicked in only after one year.
Debt investment will have three years to be qualified for Long term Capital gains.
In the same way, other asset classes will have various periods to be qualified as LTCG.
Same way, liquidity options and charges associated with investment have to be considered.
In case one is making a Systematic investment, You can go for asset rebalancing by stopping future investment in one asset class and enhancing or starting in another.
The tax-efficient way to do asset reallocation is to look for NPS or ULIP investment.
In these investments, switching from one asset to another do not attract charges or tax implications.
Do explore these options as these are more tax-efficient and tax-friendly.
Asset allocation is the most crucial aspect of a once investment journey. The process will give you the two most important parameters to work with: the quantum of money required and the period.
These two will guide you to proper asset allocation and determine your financial outcome.
I hope you would have gained some insights into asset allocation. Do Asset allocation first before diving into your investment journey.