Synopsis
Asset allocation is nothing but another name for diversification. It is how you spread your investments across asset classes— stocks, fixed income, property and gold. It ensures all your eggs are not in one basket.
Getty ImagesBy Nitin Vyakaranam
Financial planners preach it, fund managers recommend it and investment experts follow it like a religion. Yet, the importance of asset allocation is generally lost on retail investors. I have seen disciplined investors throw away the rule book and allow inherent biases to control investment decisions. The resulting asymmetry leads to sub-optimal outcomes and less than expected returns.
Unfortunately for investors, this usually happens when investment discipline is needed the most. A recent example was the market crash in March following the global outbreak of Covid-19. When they should have bought more by hiking their SIPs in equity funds, many investors actually stopped SIPs. Some even withdrew their investments. With one click of the mouse, they turned paper losses into permanent ones. Now that markets have recovered some ground, investors who panicked and withdrew will miss the uptrend.
Asset allocation is nothing but another name for diversification. It is how you spread your investments across asset classes— stocks, fixed income, property and gold. This could be based on your risk profile, nearness of your goals or your assessment of the markets. Asset allocation ensures all your eggs are not in one basket. Even if stocks crash, the other assets shore up your portfolio.
Where investors go wrong
It is also a profit booking mechanism that gets triggered when a certain asset class becomes overheated. The principle of asset allocation requires rebalancing if there is a portfolio drift. All asset classes don’t move at the same pace or in the same direction. Rebalancing realigns the portfolio so that exposure to underweight assets is increased and overweight assets are jettisoned. This allows the portfolio to carry the same risk-reward expectations despite market changes.
However, it doesn’t always work that way. Most investors tinker with allocation during external events, imposing their own perspectives on well laid plans of the asset allocation model. We have often noticed that investors become too greedy when the going is good. They are not ready to reduce exposure to equities when the markets are peaking. Some even add more to the already overweight asset class, thus increasing risk in the portfolio.
Tragically, the opposite is equally true. Many investors lose their nerve when markets go into a tailspin. They redeem investments at a loss, even though the rebalancing principle requires them to buy more equities.
Fixing the asymmetry
Investors who want to gain from asset allocation must first unlearn their biases. Advisers and wealth management firms have built asset allocation models to suit almost all types of investors. Before choosing a model, the investor must first understand his own risk profile.
Risk profiling is based on behavioural finance and psychometric testing and should not be confined to 2-3 generic questions. For example, an individual’s willingness to take risk is not the same as his capacity to do so. It cannot be assumed that an investor understands the risks involved just because he says so. Linking expectations to risk, both on the upside and downside is one of the key inputs that lead to good asset allocation.
Further, the model should be back tested for not just the good times but also for bad times. Good portfolios protect you in tough market conditions. Once you choose a model, let the quant do its work.
How good asset allocation works
To assess the performance of good asset allocation methodology, we built a few sample portfolios (see chart). Each model was divided into multiple equity and debt asset classes with varying weightages. Weightage of sub asset classes were determined using multiple parameters, resulting in particular risk, reward and duration outcomes. The portfolios were all a combination of equity and debt. The performance of the portfolios were evaluated over a year. We looked at one year specifically to understand the impact of the market collapse. The graph shows the performance returns of five portfolio models and compares them with Nifty and Crisil Hybrid indices.
Disclaimer: The comparison above is only for the purpose of illustrating the advantages of diversification and asset allocation. This is not any investment recommendation or advice. Readers are requested to consult an investment adviser before acting on it or taking any investment decisions. Past performance is not indicative of future performances.
Portfolios that have consistent asset allocation and superior product selection significantly outperform the market. The out performance in absolute returns is very large, resulting in a large alpha generation. While the portfolios were designed to generate alphas in the range of 3- 5% in the long term, they have given over 5X better results in a collapsing market.
(The author is Founder & CEO, Arthayantra)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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