Asset Allocation Guide
Asset allocation is the process of dividing our investments among different kinds of asset classes (equity, debt, commodity and cash) to minimise our risk, and also to maximise return at the given level of risk. The reason asset allocation works is because every asset class exhibits its own characteristic of risk and return that is different from others. The article provides valuable tips about how you should allocate your assets
The corona virus pandemic has reinforced one of the greatest lessons of investment. You cannot predict the short-term returns of any asset class. We saw in the last calendar year how the returns from equity first saw a dramatic fall in the first quarter and then an equally dramatic recovery from thereon. In the same duration, some of the long duration bond funds generated double-digit return. Such volatility in returns may lead to a wrong decision by investors when it comes to entry and exit from their investment, which can ultimately jeopardise overall portfolio returns. Diversification of your investment may help you to avoid such decision.
Not long ago diversification was simply to ‘avoid putting all your eggs in one basket’. The argument was that in such a scenario the range of possible outcomes becomes very wide. If you invest in a single asset you might win very big but you also face the possibility of losing very big. So if you had only invested in equity you would have witnessed the value of your portfolio declining by more than 40 per cent last year in a span of just two months. Such a large drawdown may have led to panic and you would have sold your investment at a wrong time.
This is not the first time we have seen such a large fall in the equity market and definitely not the last one. In the years 2005, 2006 and 2007 we saw the equity market giving return of more than 40 per cent every year. Nevertheless, the fall in the equity market in year 2008 would have wiped out half of your portfolio value. So if you had invested Rs 100 at the start of 2005, at the end of 2008 it would have become Rs 144.5 giving you annualised return of 9.5 per cent.
Contrary to this, if you spread your money among a number of different assets it will narrow the range of outcomes. So if you had invested 50 per cent in equity and 50 per cent in debt (10-year sovereign bond fund) and rebalanced it at the end of every year, the same Rs 100 would have grown to Rs 168, giving you annualised return in double-digit. This entire process of diversification and investing in different asset classes is perfectly summed up by Jack Bogle, American investor and the founder of The Vanguard Group who is also credited with creating the first index fund. He said, “The most fundamental decision of investing is the allocation of your assets: How much should you own in stocks? How much should you own in bonds? How much should you own in cash reserve?”
In the following paragraphs we will help you design an asset allocation plan based on your goals, timeframe, risk tolerance, and personal financial situation.
Asset allocation is the process of dividing our investments among different kinds of asset classes (equity, debt, commodity and cash) to minimise our risk, and also to maximise return at the given level of risk. The reason asset allocation works is because every asset class exhibits its own characteristic of risk and return that is different from others. They respond in a similar fashion to economic and market events. For example, the returns on the equity shares of a company would depend upon the growth in profits and the scalability of the business. This translates into the possibility of a higher long term return if the company is managed well and the performance is good.
On the other hand, returns from fixed income securities such as the bonds of a company would depend on the ability of the company to generate enough cash to pay interest even if the company is not growing. This translates into steady periodic return, with limited possibility for capital appreciation. This difference in characteristics of different assets makes the asset allocation work in a perfect way.
Now after understanding what is asset allocation and why it works, the next step in asset allocation is to find which asset class to invest in and what percentage should you invest in such asset classes. There are different ways to arriving at the right asset allocation. Nevertheless, asset allocation linked to financial goals is the most appropriate form of asset allocation strategy as it links the asset allocation to the investor’s financial goals. Determining the right asset allocation can be determined through answering these questions.
✓What are your financial goals?
✓ What is your timeframe?
✓What is your risk tolerance?
✓ What is your personal financial situation?
There are various needs for which you save and invest. You might be saving for the down payment of your home or for your child’s marriage or his or her higher education or comfortable Retire.. It’s important to have specific goals so that you know what you are saving for and approximately how much money is necessary at what time in the future. Identifying financial goals helps put in place a spending and saving plan so that current and future demands on income are met efficiently. All the financial goals are not equal importance and the type of financial goals such as needs (child’s education) and wants (going for international vacation) will determine the type of asset that you invest in.
Once you have ascertained your financial goals, the next step is to determine the timeframe when you need the required money to fulfil your financial goals. This will again help you to select the right asset class. Equity funds of any category are usually inappropriate for short timeframes (less than five years). Suppose, for example, that you are investing for your child’s college tuition, which is due in three years. Now, attracted by the 2017 Bull Run in the equity market you invested in some small-cap fund.
Unfortunately, even after three years of investment, the value of your investment would have been worth only about 60-70 per cent of its previous value depending upon the fund that you would have invested in. It’s this unpredictability and volatility of stocks that make them unsuitable for short timeframes. The table below shows the rolling return of Sensex since its inception for different periods. It clearly shows how the stock market declines and gains become less and less as investing periods lengthen and volatility represented by standard deviation also declines.
Over the 42-year period from 1979 through 2021 (June) we can clearly see that an investor who picked the worst one-year period to invest in Sensex (proxy to large-cap funds) would have lost 58.15 per cent. However, the same investment over any 10-year period would have lost maximum of 2.88 per cent. Now, we can understand why stocks are poor investments for short-term goals but can be excellent investments for long-term goals.
To understand the return from the debt funds and cash and cash equivalent we took CCIL Broad and CCIL Liquid indices respectively that serve as performance benchmarks for these assets. CCIL Broad index consists of top 20 traded bonds and the CCIL Liquid index constitutes the top five traded bonds, respectively. The Total Returns Index (TRI) provides the change due to both the price movements and accrued interest.
The above table (annualised return (per cent) of CCIL Bond Index since 2004) shows the annualised return of the indices for different periods. It clearly shows how the bonds are much more stable. They generate lesser return than equity; however, they also exhibit lower volatility and are more stable. Hence, debt funds should be given more weightage for your near-term financial goals.
Next step in deciding your asset allocation is to know your risk tolerance. In order to help determine if your portfolio is suitable for your risk tolerance, you need to be honest with yourself as you try to answer the question, “Will I sell if the market sees a plunge similar to the first quarter of CY20?” Risk tolerance is not what you do on an average day in the stock market; it is what you do when the worst is happening. This is because only in the bad period that you take the drastic step of locking the paper loss into actual loss.
The equity market or any other market (including commodity) corrects by 20 per cent or 40-50 per cent on a regular basis.
This fall may be triggered by regular business cycles or by larger credit cycles and irrational exuberance which create bubbles and recessions. You need to understand that you are allocating your investment to different assets for the bad times, not the good. Also, appropriate asset allocation will help you to follow the maxim—when you win, quit playing! Or at least dial down the risk.
The sleep test is one of the ways to help determine if your asset allocation is in accordance with your risk appetite. When setting up an asset allocation plan, investors should ask themselves: “Can I sleep soundly without worrying about my investments with this particular asset allocation?” The answer should be unequivocal yes, since no investment is worth worrying about and losing sleep over.
So if you believe that a larger fall in the value of your portfolio does not disturb you, larger allocation can be done to equities; otherwise stick to larger exposure to bonds. Below is the table that shows the worst annual return and average return with different asset allocation. For equity we have taken returns of BSE Sensex and for bond we have taken returns of 10-year sovereign bond index and the period of study is 20 years ending 2020.
Simply change your allocation between stocks and bonds in our portfolio until you reach a comfortable sleep level.
Personal Financial Situation
The personal financial situation of an investor has a direct impact on the type of security he decides to invest in and allocates within his asset allocation plan. This not only includes investments that are visible and for which you write a cheque, but also takes into account the financial characteristics of your job and long-term career, which are invisible and can be termed as human capital. It is a way of quantifying the present value of your future wages, income and salary. This human capital can exhibit the characteristics of both bond and stocks.
For example, a government employee with a pension and good medical facility has a character of bond as his income is stable and less volatile. So, such investors can increase their allocation towards equity as ‘human capital’ will form part of the bond weightage. Contrary to this, if an investor is working in a private sector company engaged in a very cyclical business, human capital in this case is akin to equity. When there is boom in the cycle he may earn handsome salary; however, in case of a down cycle, he may even lose his job.
Therefore, such an investor should lighten the equity risk and hold more bonds in his financial portfolio. In short, whenever you decide your asset allocation you should consider both financial as well as human capital.
Designing your Personal Asset Allocation
Plan It’s difficult to recommend specific portfolios as one size does not fit all. As discussed above, every individual will have different goals, timeframes, risk tolerances and personal financial situations. Nonetheless, we will try to generalise it and design an asset allocation plan based on financial goals. First, different financial goals should primarily be identified based on the timeframe. They can be:
✓ Near-term goals (less than three years away)
✓Short-term goals (between 3-5 years away)
✓ Medium-term goals (between 5-10 years away)
✓ Long-term goals (between 10-15 years away)
✓ Very long-term goals (more than 15 years away).
Once you have categorised your financial goals in terms of different time periods, the next step is to divide them into needs and wants. There are some goals that you cannot avoid such as your Retire., child’s education, medical care and others, while there are some financial goals such as international vacation or upgrading your mobile phone every year which are avoidable and can be postponed. The following table is a rough guide to your asset allocation based on your financial goals and its criticality
You should also understand that as and when goals moves towards their horizon, asset allocation should also change accordingly. For example, when you are 30 years old and saving for your Retire., you can invest up to 80 per cent in equity. As you become older and reach the age of 55, your asset allocation should now match with short-term goals and 100 per cent of your asset should go towards debt. Besides, within the broader asset class of equity and debt there are sub-asset classes. For example within equity you have large-cap, mid-cap and small-cap. For a conservative investor, equity allocation should be made towards large-cap.
A moderate or aggressive investor can invest in mid-cap and small-cap funds only if the goal is beyond 10 years. In case of debt funds, try to match the duration of the bond fund with your financial goal. For example, if your goal is three years away you can chose a debt fund that has Macaulay duration of three years. What we have discussed above is only one of the many approaches one can take to arrive at appropriate asset allocation.
Asset allocation may also be linked to the stage of an investor’s life. The lifecycle of any individual can be typically sub-divided into young investor, young couple in mid-30s, mature couple with grown up children and retired couple. Nevertheless, what remains common in all approaches is that short-term goals should have more allocation towards debt and long-term goals require more allocation to equities.