After a stock market bull run that has been on for more than ten years, we are now seeing markets that are quite expensive by historical benchmarks. Yet the optimisim continues and the allure of unending returns is pulling the indices inexorably up. The global markets are also in tune with this exuberant mood.
Some among the savvy investors who have seen the 2008 crash and are arguably a bit wiser, are wondering if these good times will last much longer. The price earning multiples of the indices are at record highs. Against this backdrop, it is prudent to cover how investors can protect their carefully built portfolios and avoid potential draw downs that could be debilitating.
Many of those stung by the 2008 crash stayed away from the equity markets and missed out on an opportunity to build significant wealth. Now the cycle has turned and we again have millions of new investors who have entered the stock markets in the recent years.
One time tested strategy to protect the portfolio from shocks and make it run on all kinds of weathers, is called Asset Allocation. We sometimes hear experts talk about Asset allocation and Rebalancing of Portfolio. We will now find out why this is almost like a free lunch in investing!
Asset Allocation Helps Reduce Risk
Asset allocation is nothing but application of a lesson learnt way back in school, Do not put all your eggs in one basket. In other words, it means that we should not invest our entire money in only one asset or asset class. Our investment should be spread across the 4 different financial assets, namely Equity, Long Term Debt, Short term Debt and Gold.
This helps us in balancing our risks and rewards and achieve our investment goals, as each of these assets serve a particular investment objective. Equity helps in growth, Long Term Debt provides stability, Short Term Debt takes care of Liquidity and Gold works as portfolio insurance.
Asset allocation is similar to having a balanced diet. One needs to eat different types of food and in some pre-determined proportion. Asset allocation is about investing our money across the different asset classes in some specific proportion. For example, Mr. A might allocate his funds across the 4 asset classes as under: Equity 45%, Long term Debt 30%, Short Term Debt 15% and Gold 10%.
Rebalancing Guards Your Portfolio Against Shocks
Shock absorbers anyone on this rollercoaster ride of investing? Re-balancing, in simple terms, is about sticking to ones asset allocation. Once Mr. A has invested let us say, Rs.100,000 across the 4 asset classes in the proportion mentioned above, his money will start growing at different rates. Let us assume that, during a period of 1 year, Equity gave a return of 20%, Long Term Debt 8%, Short term Debt 6% and Gold gave a negative return of 2%. His portfolio will now look as under:
| S.No | Asset Class | Amount invested | Asset Allocation | Return | Amount after 1 year | Asset Allocation |
| 1 | Equity | 45000 | 45% | 20% | 54000 | 48% |
| 2 | LT Debt | 30000 | 30% | 8% | 32400 | 29% |
| 3 | ST Debt | 15000 | 15% | 6% | 15900 | 14% |
| 4 | Gold | 10000 | 10% | -2% | 9800 | 9% |
| 100000 | 112100 |
When Mr. A reviews the portfolio, he is happy that he invested a larger amount in Equity as Equity gave the highest return of 20% p.a. However, he is unhappy that his overall portfolio gave a return of only 12.1%, whereas if he had invested the entire amount in Equity, he would have earned 20%, or Rs.20,000.
At this point in time, the tendency is to get out of other Asset classes such as Long Term Debt, Short Term Debt and Gold, and invest the entire amount in equity. However, investors who have learnt the lesson of diversification may not do that and allow the portfolio to remain as is.
Even if Mr. A leaves the portfolio as is, kindly note that the asset allocation has changed. Equity is now 48% of the portfolio. The proportion of Long Term Debt and Short Term Debt has fallen to 29% and 14% respectively, whereas Gold constitutes only 9% of total assets.
Let us extend this scenario to another 4 years, although it may not be possible to achieve the same returns year after year. After 5 years, Mr. As portfolio will be as under:
| S.No | Asset Class | Amount after 5 years | Asset Allocation |
| 1 | Equity | 1,11,974 | 60% |
| 2 | LT Debt | 44,080 | 24% |
| 3 | ST Debt | 20,073 | 11% |
| 4 | Gold | 9,039 | 5% |
| 1,85,167 |
Nothing wrong with that, except that Equity is now 60% of the total portfolio, as opposed to the original asset allocation of 45%. Is that a problem? Let us assume that year 6 experiences a global turmoil and there is a 40% fall in equities, Debt continues to earn same rates but Gold has shot up by 20%. Mr. As portfolio at the end of the 6th year would be as under:
| S.No | Asset Class | Amount after 5 years | 6th Year returns | Amount after 6 years | |
| 1 | Equity | 1,11,974 | -40% | 67,185 | 46% |
| 2 | LT Debt | 44,080 | 8% | 47,606 | 32% |
| 3 | ST Debt | 20,073 | 6% | 21,278 | 14% |
| 4 | Gold | 9,039 | 20% | 10,847 | 7% |
| 1,85,167 | 1,46,916 |
There appears nothing wrong with this. However, if one were to look at returns earned over the period and more importantly, if one of the financial goals were to be met during the 6th year, there could be a huge setback due to sudden fall in equities in the 6th year. This is because we did not rebalance the portfolio every year.
Periodic rebalancing guides you to your goals
In our example, the asset allocation at the beginning and end of the first year changed, as the returns varied across different asset classes. Out of total portfolio value of Rs.1,12,100, equity is Rs.54,000, whereas as per the asset allocation plan of Mr.A, it should be only 45%. Having adequate liquidity ready for your goals is very important here.
In other words, in a portfolio of Rs.112,100, equity at 45% should be Rs.50,445 (45% of Rs.112,100). Thus, equity is more to the extent of Rs.3,555. As part of rebalancing, Mr.A needs to sell equity to the extent of Rs.3,555. Similarly, Gold, which should have been 10% of portfolio, or Rs.11,210 in value is only Rs.9,800. The investor needs to buy Gold to the extent of Rs.1,410.
This table explains the Rebalancing to be done:
| S.No | Asset Class | Amount invested | Asset Allocation | Return | Amount after 1 year | As per asset allocation | Action to be taken | |
| 1 | Equity | 45,000 | 45% | 20% | 54,000 | 50,445 | Sell Equity | -3,555 |
| 2 | LT Debt | 30,000 | 30% | 8% | 32,400 | 33,630 | Buy LT Debt | 1,230 |
| 3 | ST Debt | 15,000 | 15% | 6% | 15,900 | 16,815 | Buy ST Debt | 915 |
| 4 | Gold | 10,000 | 10% | -2% | 9,800 | 11,210 | Buy Gold | 1,410 |
| 1,00,000 | 1,12,100 | 0 |
Rebalancing enforces discipline
Contrary to general investor behaviour of investing more in asset classes that yield more returns, Re-balancing forces the investor to sell / redeem assets that have given higher return and buy assets that have given a lower return. This is an example of Rupee Cost Averaging. Thus, over a period of time, one accumulates more at lower levels and actually books profits at higher levels, resulting in higher overall long term returns.
Of course, Rebalancing as a strategy may appear too conservative, if an asset class is on a continuous upward trajectory giving super normal returns year after year. However, even in this case, the original asset allocation is always maintained and the investor does not lose out much. It is just that she could have made more by having a higher allocation to such asset.
Unfortunately, we do not know in advance how the asset class is going to perform. We do know that, most of the times, returns from any asset class are not consistently above or below average market returns. In this situation, rebalancing not only protects our gains but also enhances overall portfolio returns.
Make sure you rebalance once a year at the least
It is recommended that this exercise is carried annually or when the investor feels that there is a significant change in circumstances. Investors must guard against knee-jerk reactions and certain macro events and rush to make changes in their allocation.
It is recommended that an investor not only rebalances the portfolio as per his/ her asset allocation, but also takes the opportunity to review his/her portfolio in the light of change in circumstances from the time the allocation was earlier done to the time of review.
Take Professional Help
Taking professional help is highly recommended to arrive at the asset allocation that is specific to an investor, based on his/ her goals. A trusted advisor who works without conflict of interest will always work for protecting and growing your wealth. A commission-based advisor may have other interests.
It is very difficult to take the emotional decision of selling an apparently high performing fund, or buy in a falling market. SEBI Registered Investment Advisors at Jama.co.in can be trusted to give you the right advice, hand-hold you in the process of arriving at your specific asset allocation based on your goals and risk profile, as well as for periodic review and rebalancing.
Check this Vanguard report on how an advisor can add significant alpha to your portfolio by helping with asset allocation and rebalancing. The unbiased advice that only a SEBI RIA and a Direct Mutual Fund Platform can give you is an unbeatable combination.
If you are switching from regular or indirect mutual funds to Direct Plans, rebalancing is also a good time to spring clean your portfolio and set it up right. Dont just switch to the same fund’s direct plan.
In conclusion
Balancing our risks and rewards and achieving our investing goals, as each of these assets serve a particular investment objective. Equity helps in growth, Long Term Debt provides stability, Short Term Debt takes care of Liquidity and Gold works as a portfolio insurance.
Asset allocation is similar to having a balanced diet. One needs to eat different types of food protiens, carbohydrates, fats, minerals in some pre-determined proportion. Asset allocation is about investing our money across the different asset classes in some specific proportion that augurs well for our financial health.
Happy Investing!