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Portfolio: Asset allocation vital in volatile markets

It is time to evaluate your asset allocation and balance your portfolio again
The five-year bull run which we saw prior to 2008 had made concepts like debt, asset allocation, and financial planning quite unfashionable. The only investment destination one could think of was equity, thanks to the soaring stocks markets. Times have changed and so has the thinking. Investors are now giving more relevance to asset allocation and planning of investments keeping in mind the long-term financial goals.

A strategy which always works well in the long term is asset allocation. Asset allocation essentially means diversifying your money among different asset classes such as equity, debt and cash. This would depend on an individual's risk tolerance level and return expectations. The strategy also works well because different asset classes have a tendency to behave differently. While stocks can offer potential for growth, fixed income instruments can offer stability and income. This augurs well for the overall portfolio and balances the risk and reward.

So, if an investor were to devise an asset allocation strategy with respect to equity and debt, how would he go about it? First, let us understand what comprises equity and debt. While equity would mean individual stocks and equity mutual funds, debt would comprise fixed income instruments, bonds (medium to long-term) and money market instruments (short-term).

The goal of asset allocation is to create an efficient mix of asset classes that have the potential to appreciate while meeting your risk tolerance level and investment objectives. The key considerations for deciding the composition of the investment portfolio and amount of investment in each asset are expected returns and risk, time horizon, liquidity needs and tax aspect. The thumb rule is that the younger the investor, higher is the risk tolerance and time horizon, and hence greater should be the allocation to equity. A generalisation can be made that 100 minus your age should be the allocation to equity. This however needs to be altered based on risk appetite.

Based on risk tolerance there could be three types of portfolios:

  • Aggressive portfolio: Equity - 70 percent, long term debt - 20 percent, short term debt -10 percent.

  • Moderate portfolio: Equity - 50 percent, long term debt - 30 percent, short term debt - 20 percent.

  • Conservative portfolio: Equity - 25 percent, long term debt - 50 percent, short term debt - 25 percent.

The other crucial aspect of asset allocation is monitoring it. For example, if a person invests his money in equity and debt on a 50:50 ratio and if the market value of his equity investments drops to 40 percent, what should he do?

There are different asset allocation strategies he can adopt:

  • Buy and hold strategy:

This is a do-nothing strategy and no rebalancing is done.

  • Tactical strategy:

Depending on the prospects of a particular asset class, its proportion is increased or reduced to take the benefit of the movement. This strategy is risky and works only occasionally, hence best avoided.

  • Balanced asset allocation:

In this strategy, the proportion of assets is maintained, i.e., whenever the value of an asset class goes down, it is bought by liquidating a part of the asset class which has gone up. This strategy works well since one would buy cheap and sell high. However, this should not be done for a small increase or decrease. An increase or decrease of 10-15 percent would be a good level to act upon.

Time to act

During 2007, the proportion of equity in the overall portfolio would have gone up quite dramatically, thereby indicating a sell. Consequently, after the market downturn, the proportion of equity in the portfolio would have dropped, indicating a buy. So, rather than worrying about where the stock markets would go, you should monitor your investment portfolio based on the asset allocation principle, and take appropriate action. After all, asset allocation is probably the most important decision and may account for more than 80 percent of the returns from your portfolio.

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