The Importance Of Asset Allocation And Re-Balancing

One of The Best Ways To Protect Unexpected Shocks

Asset allocation along with periodical re-balancing of your portfolio will help you to earn better risk-adjusted returns 

You might have come across various headlines such as: ‘Market continues its losing streak’, ‘BSE, NSE halt trading for first time in 12 years’, and so on.

Indeed, it seems like equity markets are heading towards a major fall. If we look at the returns of S&P BSE Sensex year-till-date (March 20, 2020), then it is negative 25.88 per cent. Even one week’s returns stand at negative 14.19 per cent. S&P BSE Metal index and S&P BSE PSU index lost as much as 39.76 per cent and 32.85 per cent respectively on YTD basis. This was led by fear among investors due to the corona virus outbreak. Besides, there are other reasons that are spooking the equity market. Apart from corona virus, the fears with respect to health of the US economy along with slowdown in Indian economy, fall in crude oil prices and selling pressure from foreign portfolio investors (FPI) are some of the other reasons that have led to such an intense fall in the stock market. Besides these fundamental reasons, what have also impacted the market are investors’ sentiments and emotions, which follow their own cycles. It starts with optimism which further leads to excitement followed by thrill and euphoria. With this it moves on to anxiety, denial and fear which further leads to desperation and panic, resulting into depression. The below image would help you understand how sentiment works.

However, many a times it happens that people enter the market during the euphoria phase and exit the market during depression. In fact, one should do exactly the opposite. However, for most of the retail investors it would be difficult for them to time the market while keeping aside all emotional biases. Therefore, asset allocation is the perfect solution for most of the investors. Asset allocation along with periodical re-balancing of your portfolio will help you to earn better risk-adjusted returns. In the following graphs we would walk you through asset allocation and re-balancing and also highlight with the help of illustrations how you can tide such roller-coaster rides of the market.

What is Asset Allocation?

The most fundamental decision that you will ever take about your investment and portfolio is the allocation of your assets into different asset class. How much should you own in stocks? How much should you own in bonds? How much should you own in cash reserve? How much should you own in precious metal? Every asset class has its own characteristics and different asset classes behave differently in different market conditions. And asset allocation is an investment strategy to invest in different asset classes to contain the risk involved by investing in a single asset. Basically, asset allocation lowers risk by dividing your investments among different asset classes that are most probably not correlated to each other. Further, to decide the appropriate proportion in which you need to invest in those asset classes, you need to first assess your risk appetite. The reason behind the same is that every asset class has its own risk and every investor has a different risk appetite. Say, for instance, if you are someone who cannot stomach losses greater than 5 per cent to 10 per cent, then you are a conservative investor. Hence, you should be investing majorly in debt and gold than in equity. Also, asset allocation works better if it is periodically re-balanced.

What is Re-Balancing?

As different assets behave differently, they would have different returns in each period. Therefore, your original asset allocation would change at the end of a period. Assume, for instance, you invested Rs 50,000 in equity and Rs 50,000 in debt. This means you have 50:50 asset allocations. Let’s further assume that in the next year equity gave 10 per cent returns and debt gave negative 2 per cent returns. Then the value of your equity would be Rs 55,000 and that of debt would be Rs 49,000. The value of your portfolio is now Rs 1.04 lakh. This will bring your asset allocation to around 53:47 as against 50:50. Therefore, to restore it back, you need to re-balance. This means you would need to sell one asset and buy another to maintain the asset allocation. In our example, to restore asset allocation of 50:50, you would need to sell Rs 3,000 from equity and buy Rs 3,000 worth of debt. This is how re-balancing works.

Importance of Proper Asset Allocation and Re-Balancing

There are various studies that favour asset allocation and periodic re-balancing of your portfolio. In 2003, The Vanguard Group did a study using a 40-year database of 420 balanced mutual funds. It found that 77 per cent of the variability of a fund’s return was determined by the strategic asset allocation policy. Market timing and stock selection played relatively minor roles.

Asset allocation basically helps in reducing risk through diversification across various asset classes. Historically, the returns of stocks, bonds and gold have not moved in the same direction. In fact, market conditions can lead to one asset outperforming in a given period and causing another to underperform. Therefore, at a portfolio level it results into less volatility for investors as movements in them offset each other.

The table below shows the daily return correlation between different asset classes for the last 20 years.

It clearly shows that there is negative correlation of ‘gold’ with both equity represented by Sensex and debt represented by long duration bond funds.

Asset allocation often helps investors to ensure that they reach their financial goals. For instance, if an investor is not taking enough risk then he or she might not be able to generate enough returns. On the contrary, if an investor is taking excessive risk again he or she might not have enough money when the person actually needs it due to volatility in returns. Therefore, having the right asset allocation is equally important to avoid such issues. This means that your investment experience would be more or less consistent.

Re-balancing your portfolio helps you to further control the risk by ensuring that your portfolio is not dependent on success or failure of one asset class. Without re-balancing you might be exposed too much risk to a particular asset, which might work when in a bull phase but will be disaster when markets enter a bear phase. For example, if one would have done his asset allocation right at the start of 2017 and failed to re-balance it, he would have been staring at huge losses now. Re-balancing helps you to book profits and invest in asset that has underperformed for the period but is going to outperform going ahead. Always ensuring that you periodically restore your asset allocation will help you to avoid taking any unnecessary risk. Hence, it is important to periodically re-balance your portfolio.

Portfolio Performance: With and Without Asset Allocation

To better understand whether asset allocation and re-balancing works we carried out a study. In this study we considered S&P BSE Sensex to be the representative of equity asset class, S&P BSE 10-year sovereign bond index of debt and for gold we considered gold prices. The period of study is from the year 2000 to 2019. While doing asset allocation we have assumed total investment of Rs 1 lakh that is equally divided among equity, debt and gold. This will bring asset allocation to 33.33 per cent equity, 33.33 per cent debt and 33.33 per cent gold. We have compared the outcome of what if asset allocation and re-balancing was applied and what if it wasn’t.

As can be seen from the above graph, if you would have invested in an equally weighted portfolio then it would have proved to be better than investing in individual assets. Here, portfolio means portfolio with asset allocation and yearly re-balancing

In the above table, the mean returns seems to be somewhat similar, except for debt that has mean returns of 0.7 per cent. However, geometric mean gives a clearer picture with portfolio and gold performing better than equity and debt.

Looking at the returns in the first quartile, debt performed better followed by the portfolio with asset allocation. Median returns show that gold is being better followed by equity and portfolio. In the third quartile, equity and gold performed better than debt and portfolio.

Given that, in terms of variance, debt and portfolio have the least variance with respect to its mean than equity and gold. Even in case of standard deviation, debt and portfolio have low standard deviation compared with equity and gold. This shows how a portfolio is able to control the risk.

Also, to understand how much risk is taken for every unit of returns generated, we calculated Sharpe ratio. More the Sharpe ratio, better it is. And, a portfolio with asset allocation and re-balancing strategy goes ahead of individual asset classes in this metric. Therefore, we can say that asset allocation with re-balancing works better than relying on individual assets.

Portfolio Performance: Asset Allocation with Re-Balancing and Without Re-Balancing

Now we will check a situation where we have not done any periodic re-balancing and a situation where we have done a yearly re-balancing.

As can be seen from the above graph, the second portfolio is better than the first one. The first portfolio here is with asset allocation but without re-balancing and the second is with asset allocation and re-balancing. The below table will show you the returns and other risk statistics:

As can be seen from the above table, in each and every parameter, the second portfolio looks better than the first one. This shows that not just asset allocation but along with it periodic (mostly annual) re-balancing is important. Therefore, while adopting this strategy, do re-balance your portfolio at least annually.

Going Deep
Further analysis would help us understand various facts with respect to asset allocation and re-balancing strategy. For further analysis we took monthly data of Sensex, 10-year sovereign bond index and gold for the period January 2000 to December 2019. Also, we created a portfolio with equal weightage to each asset class with annual re-balancing .

As the graph show, that portfolio did better than individual asset classes with comparatively low volatility and lower drawdown. This means that your investment experience would be much better than investing in individual assets. We have plotted the drawdown to understand its true volatility. The drawdown of equity is the highest followed by gold and debt. However, it is the least for the portfolio that was created using asset allocation and re-balancing strategy.

Asset Allocation and Different Risk Profile
Risk is directly related to returns. This means that more the risk more the returns and vice versa. Therefore, it is important to understand an individual’s level of risk tolerance and create asset allocation strategy depending on the same. To understand how it works, we assumed three risk categories viz. low, medium and high. The proportions of the same can be seen in the below table:

As the above graph indicates, the portfolio with low risk profile has not able to beat gold but was able to give good investment experience to the person who cannot stomach losses. You can see how less volatile it is compared with gold and Sensex. Therefore, it works well for investors with low risk profile.

FAQs on Assest Allocation

Is this strategy for everyone?
Yes! Asset allocation and re-balancing strategy is for everyone. Specifically, for those having financial needs and have lack of knowledge and time to manage their investments. For people investing for wealth creation, dynamic asset allocation would be a better strategy to adopt.

Should asset allocation be same as taken in the study?
Not at all! The asset allocation would differ from person to person. The asset allocation assumed in the study is just a hypothetical example to understand how asset allocation and re-balancing works against individual asset classes.

Does one need to consider his or her risk profile for deciding asset allocation?
Absolutely yes! In fact, risk profile would be one of the major determinants of asset allocation. Therefore, before deciding on your asset allocation strategy it is important to assess your risk profile. For instance, if your risk profile works out to be aggressive, then your asset allocation would be more tilted towards equity whereas if it turns out to be conservative then it would be more tilted towards debt and gold.

What if one has financial goals?
This strategy works well if you link your investments to financial goals. In fact, this will further help you in deciding your asset allocation. For example, if your risk profile is aggressive and your financial goal is two years away or say the goal is for your child’s education, then in such situations your asset allocation strategy would be completely different. Different financial goals would have different asset allocation strategy depending upon their nature and tenure.

Actual Performance Of Mutual Fund Portfolio With Asset Allocation

This was actual portfolio created dated August 8, 2019 as our paid services that was benchmarked against S & P BSE 500. The portfolio compromised 80 per cent in equity that was again divided into large, mid and small-cap dedicated fund, 15 per cent in debt and 5 per cent in gold. The below table would give you an idea with respect to returns and risk parameters: 

The above table clearly shows that in terms of most of the parameters our portfolio performed better than its benchmark. Even looking at the graph will show you that even in the current volatile situation our portfolio performed better than S & P BSE 500. Therefore, we can say that indeed asset allocation with re-balancing strategy works.

"The difference between success and failure is not which stock you buy or which piece of real estate you buy, it's asset allocation. "

Tony Robbins

In case of investor with medium risk profile, the portfolio with asset allocation and re-balancing strategy was able to beat all the individual asset classes. Also, in terms of volatility it is comparatively less volatile than gold and Sensex, although it is more volatile than the portfolio of a low risk profile investor. Indeed, the volatility of the portfolio of a high-risk profile investor is higher than that of low and medium risk profile. But comparing it with investment in individual assets it still works better. Therefore, we can say that irrespective of risk profile asset, allocation and re-balancing strategy does work in the long term.

Conclusion
As we can see from our study and analysis, asset allocation and re-balancing strategy is one of the most effective investment strategies when compared with investment in individual assets, though in some cases individual assets look to be better than this strategy in terms of returns. But when we take a look at risk-return metric such as Sharpe ratio, this strategy seems to be better than investment in individual assets. Solely investing according to the asset allocation does not help. Rather rebalancing periodically makes this investment strategy more effective. Therefore, don’t just allocate assets and forget it, but also re-balance it periodically to stick to your asset allocation strategy.

Risk profile and financial goals are some of the major aspects that would help you to define your asset allocation. Therefore, before adopting this investment strategy it is advisable to assess your risk profile and then invest accordingly. Also, this strategy would be more suitable for retail investors who have lack of knowledge and time to manage their own portfolio. In addition, this strategy would be for those having financial goals to achieve. However, for those with only wealth creation goal in place, he or she should consider a dynamic asset allocation strategy. With a dynamic asset allocation strategy, one would require to adjust asset allocation depending upon the market situation. All in all, we can say that asset allocation with re-balancing strategy does give you better investment experience with comparatively less risk.