If you knew of an investment strategy that generates 90% of your returns, how much of your research time would you allocate to it? We are assuming the first answer that came to your mind was definitely above 80%. If our assumption is correct, then why do majority of us spend less than 10% of our time on this important concept and 90% on product selection and trying to time the market? We will come to that but we can already sense your curiosity to know about the investment strategy in question. You may have heard of it but may not have thought of it in this context, it is Asset Allocation.
In simple terms, asset allocation is the amount of money you invest in the different asset classes, such as cash, gold, real estate, stocks and bonds. It helps to maintain a balance between risk and returns. Research results across the world has made it clear that Asset Allocation is responsible for more than 90% of your portfolio returns whereas, Asset selection and market timing less than 10%. Yet we spend 90% of our time on the latter because it is exciting and we are overconfident of our investment selection process.
We believe in the Asset Allocation process and have consistently got high double digit returns over a long period, irrespective of up’s and downs in the markets.
So, the strategy looks promising, but how does one go about it? Let’s get to that now.
3 Key Action Steps in Asset Allocation Process
There are some key quantitative and qualitative indicators that can give you a good sense of which stage of the cycle you are in. Based on your analysis, you have to take a call on the probability whether the market will change its course or continue on its path over the immediate future. Easier said than done but just because it is not easy, does not mean you can ignore this step in your investment process.
1. Determine where you are in the Market cycle
It is proven again and again that no one can time the market, but the overconfidence of retail investors in their abilities to time the market surprises me, especially ones who do not spend even an hour a month on researching the markets. That being said the record is not any better for even the economists. In simple terms, stick to what is doable i.e. you cannot predict what will happen exactly in the future but you can determine where the markets are currently in the cycle.
2. Determine your Asset Portfolio Mix
Once you have taken a call on the market cycle, you have to come up with a strategic asset allocation plan, a fancy term for what should be the portfolio mix e.g. for financial assets, the mix can be aggressive i.e. 70% in Equity 30% in Debt or conservative i.e. 30% in equity 70% in Debt. Please keep in mind that 70% and 30% are just used as an example. In reality, there is a whole range of allocation numbers based on the probability call we make in Step 1.
You can determine the asset mix based on your current age too. However, my experience shows that rule of thumb approaches like these, will give you average returns at best, over the long term.
3. Determine the frequency of rebalancing your Asset Portfolio
Since the price of the assets keep on changing continuously the proportion of asset mix also keeps changing so, to manage the risk and returns of your portfolio, you will need to rebalance it periodically. But how often should you do it? The answer will vary based on the method that you choose.
For example, in calendar rebalancing you will determine the proportions of the assets on a half yearly or annual basis. However, in percentage rebalancing there is a trigger whenever a percentage range is breached for a particular asset.
For example, consider your portfolio has a mix of equities and bonds in the ratio 60:40 respectively and you set the percentage range breach as 10%. After 3 months because of a bull run, let’s assume the ratio becomes 70:30 because the equities portion has increased. To rebalance the portfolio, you can sell some equity units or buy more debt units to get the ratio back to 60:40.
Which method of rebalancing should you choose, the answer depends on how much time you have at your disposal to manage your portfolio. I personally prefer the calendar rebalancing and follow once a year rebalancing strategy for the following reasons:
a) I do not have to continuously monitor my assets which is generally a good thing in investing.
b) There are tax implications for churning your portfolio e.g. if I sell equities in less than a year, there is a short-term capital gain tax of 15% in India which brings my returns down. In mutual funds there is an exit load in addition to the tax.
In one off cases, where the market valuations have corrected or increased significantly over a short period and you believe, the potential returns will more than compensate for the loss through taxes and exit load then rebalance the portfolio. However, this should not become a norm else, the transaction costs will eat in to your long-term returns.
In conclusion, if you want to generate high returns and manage risks at the same time, asset allocation should be your top priority and you should give it the time it deserves.
Remember the 3 Key Action Steps:
• Determine where you are in the market cycle
• Determine your Asset Portfolio Mix
• Determine the frequency of rebalancing your Asset portfolio.
Research Desk
Everguard Life Ventures Pvt. Ltd.
everguardlife.com 