The Hindu Business Line : The right asset mix

While an asset allocation plan eliminates a lot of day-to-day decisions involved in investing, reviewing the portfolio regularly is necessary to stay on track.

A.V. Pai

Amit, a professional, had invested a big sum in stocks last year. His joy knew no bound when he saw his investment value grow from Rs 15 lakh to Rs 24 lakh in January 2008.

However, the euphoria evaporated when, within the next six months, his portfolio “value” plunged to Rs 12 lakh, a decline of 50 per cent. Could he have locked into the gains when they were available? How was he to know that the stock market would fall? Asset allocation may be the answer.

What is Asset Allocation?

As we all know, risk and return are interrelated. The higher the risk, the higher the return and lower the risk, lower is the return. Different asset categories have differing risk profiles and return potential.

Asset allocation means allocating specific proportions of your portfolio to different types of investments such as stocks, deposits, bonds, real estate, commodities and cash. Stocks, for instance, offer potential for both capital appreciation and dividend income, while fixed deposits provide safe and steady income. The benefits of different asset categories can be combined into a portfolio to obtain a level of risk you find tolerable.

Research studies have shown that proper asset allocation is more crucial in deciding your long-term return than the choice of specific investments. Since guessing which asset category will perform the best at any point in time is difficult, it makes sense to diversify your investments among various assets in a specific proportion.

How to choose the right asset mix?

Asset allocation decisions take into consideration the following factors:

Time horizon

Risk

Personal choices

Liquidity

Depending on your age, lifestyle and family commitments, your financial goals will vary. A young person may have goals such as buying a car, planning a long vacation with friends etc. A middle-aged person may be looking at children’s education, buying a home etc. A retired person will look at medical expenses or buying a farm house. You need to define your investment objectives and a time-frame for the same.

Besides defining your objectives, you also need to consider the amount of risk you can tolerate. For example, a retired person will be looking at income with stability and may need to have higher allocation to bonds and cash. When you need the money, liquidity is another important consideration for determining the asset mix. It is advisable to have a higher allocation to bank deposits and liquid funds, if you have a high liquidity preference.

Asset allocation plans change with time

While an asset allocation plan eliminates a lot of day-to-day decisions involved in investing, it does not mean you set a criteria and leave it at that. Reviewing your portfolio regularly to monitor and rebalance your asset allocation is necessary for you to stay on track to meet your long-term financial goals.

It is important to review your portfolio every three-six months to assess your progress. If a particular asset has appreciated beyond its stated allocation, you should consider selling that portion and re-allocating to other assets. That is termed re-balancing.

Re-balancing brings discipline to equity investing. It makes you sell and book profits when the market goes up and forces you to invest when the market is down. Thus, it makes one follow the time tested philosophy of equity investing — buy low and sell high. Normally, we tend to do the opposite — sell when the market falls and buy when it rises.

Taking Amit’s example, he had started out with Rs 15 lakh in equities and Rs 15 lakh in fixed income. The equity portion grew to Rs 24 lakh in December 2007. Assuming he had reviewed his portfolio then, he would have found his equity allocation overshoot by about Rs 4 lakh (assuming fixed income of 8 per cent per annum). To rebalance, he would have had to liquidate Rs 4 lakh worth of equity. That may have helped protect his portfolio value, when the equity market crashed by 50 per cent! Most of us do not rebalance our portfolio at regular intervals. The reasons could be disinterest or sluggishness. Another reason could be tax-liability, which may accrue during this re-balancing. But most of the time it is greed.

So when equities move up, you expect it to go up further and not book profits. And when it crashes, you repent the opportunity lost. You can do away with the same by having a prudent asset allocation strategy and rebalancing from time to time.

(The author is a freelance writer.)

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