In the pursuit of earning highest possible returns many investors keep chasing the asset class which has done well in the recent past. In the process, many a time they buy the asset at a price when it has reached the bubble zone. They end up losing money. Earning high returns without risk is almost an impossible task. This is because every asset class goes through different phases. This brings fluctuation in price movement of asset classes. A sensible way to seek healthy risk-adjusted returns is to follow a disciplined approach of asset allocation and systematically rebalance your portfolio from time to time.
Asset allocation simply means allocating money to various asset classes taking into account financial goals and risk-taking capacity in a particular time-frame and proportionate expectations of returns from those asset classes. For instance, a 35-year old working professional with high risk-taking capacity can save for his retirement due in the next twenty-five years by investing 70% in stocks, 25% in bonds and 5% in gold. Another investor wanting to save money for down payment for a house purchase two years from now can invest a significant portion of his investible surplus in low risk fixed income schemes, arbitrage funds or plain vanilla fixed deposits.
Carefully-crafted portfolios using strategic asset allocation is of immense value for investors yet a much under appreciated fact. There is a clear path towards one’s financial goals. But this is not an auto-pilot project. It requires constant monitoring. As investors move closer to their financial goals, they should be moving more towards less risky assets. Take for instance investors preparing for retirement. They may invest 80% of their money in bonds and 20% in equities. This is an ideal asset allocation for retirement fund. Such investors who are nearing retirement should implement this structure in their portfolio when they turn 55.
A key aspect in understanding about asset allocation is that it is a lot about asset rebalancing. Changing investors’ needs, time-frames, size of financial goals should be factored in while ascertaining asset allocation. Over a period of time, asset allocation to each asset class changes due to movement in asset prices. In such circumstances investors should take stock of the situation. Asset class to which the allocation has gone up substantially should be sold and the proceeds can be used to spruce up investments in asset class for which the allocation has gone down. For example, an investor started investing with 70% in equity and 30% in bonds in April 2019. But in April 2020 she realised that her equity investments lost 30% in value and bonds appreciated by 8%. In that case she has to rebalance her portfolio by selling bonds and using the proceeds to buy equities in such a way that her portfolio’s asset allocation (of 70:30) is restored. This way she can effectively benefit from asset price movements. Asset rebalancing should be done at least once in a year. Investors are better off not overdoing it as each transaction may entail transaction cost and tax implications.
Investors can also choose to rebalance their portfolios by following a rule-based framework to take advantage of wild swings in asset prices. For example, if an investor has built in 12% expected return in a year from equity allocation and she sees more than 40% movement—that is more than three years’ returns—in say the next six months then she may choose to rebalance her portfolio to take advantage of price movements. Such rule-based asset rebalancing can complement asset rebalancing. On the whole, a thing that makes asset allocation an effective strategy is this ability of investors to be alert to any development regarding an asset class.
An oft-quoted phrase on the Dalal Street is “Skin in the Game”.
This means you are not invested fully by investing just money. Investing requires full commitment in terms of keeping yourself abreast of latest developments about your investments. Only then your investments will bear fruits and your hard-earned money will reward you amply.