Benchmark Investments

Asset allocation is a useful tool to manage systematic risk because different categories of investments respond to changing economic and political conditions in different ways.

When you allocate your assets, you decide—usually on a percentage basis—what portion of your total portfolio to invest in different asset classes, like stocks, bonds, and cash or cash equivalents. You can make these investments either directly by purchasing individual securities or indirectly by choosing funds that invest in those securities.

Asset allocation importance describe in below image

The first step of asset allocation – the strategic step – is finding an asset allocation breakdown that meets your individual needs. This means that you should end up with a breakdown that you can live with no matter what happens in the market; even in the case of an extreme shock triggering a temporary markdown of the portfolio. You should not lose sleep over your investment portfolio.

Markets are subject to shocks every once in a while and the risk premia investors are vesting by investing in bonds, equities, and other types of financial investments fluctuate all the time. This triggers ups and downs and mark to market volatility in portfolios. In the case of external shocks, which can be pretty extreme, the temporary impact on the portfolio can be quite harsh. The other case when portfolios suffer a significant drawdown is when the economy goes into a recession. Your strategic allocation should be such that you can survive these events in the markets.

The first question you need to ask yourself when deciding upon your asset allocation is ‘what is my investment objective’? Here, the most important step is defining your risk tolerance, as you will calibrate your asset mix as a function of the amount of risk you are willing to take. The return of the portfolio over time will be a function of the amount of risk you have been willing to accept or not.

Once you have defined your risk tolerance, you can begin allocating your assets. There are various ways to build an asset allocation, but the one way that I have rejected from very early on in my career is the backward-looking way. This method involves looking at past returns and correlations, but given that the starting point is different, the outcome will be different too. Furthermore, all of these models rely on correlation assumptions and a high degree of stability in correlation between assets. But history shows that correlations are the exact opposite: they are very unstable. In other words, the way that each and every asset class behaves in relation to the others is not stable over time.

Once you have decided on your asset class breakdown, you need to decide how you are going to implement each and every asset class that makes up your portfolio. Will you pick a fund? Will you pick an ETF? Will you buy direct securities? Will you invest passively or actively? For both active and passive investing, you have to pick the right instrument and this is about making sense of the whole portfolio, because the sum of the parts is far more important than each and every individual part.

The next consideration is the time horizon of your investments. If your strategic allocation is well calibrated with regard to your risk tolerance, the longer the time horizon, the better. This is in every investing textbook. But the matter is – life is uncertain and as Keynes said, in the long run we are all dead. The paradox is that the longer you are patient, the less uncertain investing becomes. Of course, you cannot tell everyone that they need to wait for 20 years; commercially it is simply not viable. Only a pension fund with extremely clear liabilities can do that. Therefore, I think that a four- to seven-year horizon is a reasonable, pragmatic timeframe for a private investor. You should not spend too much time predicting the future. You need to diversify precisely because the future is unknown and is very uncertain.

Within that window, though, you might be tempted to adjust your portfolio. Most of the time it is important to stay the course and stick to your strategy. Whether you should act and do something different will be a function of what happened in the markets. I always say that an investment manager can only be as good as the opportunities allow him to be. There will often be opportunities along the way to either take some profits and reinvest some capital in other asset classes or to rebalance or buy more of what you already own but it is really the markets that provide these opportunities over time. The volatility regime will also be very important. There will be times when volatility will be low and the dispersion of asset return is rather low, so why would you move? But there will also be times when volatility is higher, providing opportunities to trade.

Rebalancing has the merit of bringing discipline. You could argue that someone who is very young, with a very long time horizon could start with half equities, half bonds. Eventually over time, the equities would outperform the bonds, so the share of equities will increase. But the circumstances of individuals will change over their lifetime; their liabilities, their family, their personal situation will change, so no rebalancing is not an option either.

In short, you should fundamentally revisit your strategic allocation once a year. Again, I cannot emphasise enough how important the secular outlook is, as you need to understand the structural trends and then position yourself accordingly. If you rebalance, the frequency of the rebalancing should be at a maximum once a year, and not at the end of the year. Rather, it should be on June 30, the way that endowment funds typically practice rebalancing.

Different asset classes outperform / underperform each other in different market conditions; without rebalancing, your asset allocation can deviate significantly from your target allocation.

In the chart below, we have shown how the asset allocation of a portfolio comprising of 50% equity and 50% debt (at the beginning of 2011) would change over the next 10 years without rebalancing. You can see that without rebalancing your equity allocation was well below 50% in the first 3 years and is above 50% for the last 4 years. Asset rebalancing is therefore, required from time to time to bring asset allocation back to the target. Asset rebalancing reduces downside risks in volatile markets and may potentially give superior risk adjusted returns.

Source: National Stock Exchange, Advisorkhoj Research, 1st Jan 2011 to 31st December 2020. Equity: Nifty 50 TRI; Debt: Nifty 10 year benchmark G-Sec Index. Disclaimer: Past performance may or may not be sustained in the future.

Asset allocation is not necessarily always investing in multiple assets, at the same time. Asset allocation is not about securing higher returns but it is more about earning a stable income, Asset allocation cannot ignore your risk profile result. The overall portfolio construction strategy must be in line with your risk profile.

Source: National Stock Exchange, Advisorkhoj Research. Large Cap: Nifty 100 TRI; Midcap: Nifty Midcap 150 TRI; Small Cap: Nifty Small Cap 150 TRI. Returns calculated as on 30th June 2022. Disclaimer: Past performance may or may not be sustained in the future. The chart above is purely for investor education purposes and should not construed as investment recommendation.