Most investors take decisions based on market levels. If the markets are very high, they will wonder what to do and wait for some corrections. If markets are down, they still wonder what to do and still wait for another correction. They are so confused with the whole exercise of timing the market and it’s easy and very common for investors to take incorrect decisions and make wrong investments. If their investments perform well, it’s difficult to know whether it is due to wise decisions or simply luck. Fortunately, for a savvy investor can help to ease the effects of both unpredictable luck and poor-decision making. One strategy for doing that is diversification via asset allocation:
Before you build an asset allocation strategy, it’s important to understand individuals’ measureable goals that are both financial and non-financials based on a plan with specific. No two people will have the same goals, so an important first step is how long you have to fund your goal? In general and depending on your appetite for risk, the longer your time horizon, the more risk you may want to consider taking in pursuit of long term growth. For example, a young investor with decades until retirement might hold a large percentage of his portfolio in equities.
Understanding Asset Allocation
In simple terms, asset allocation is the exercise which involves dividing your money into different asset classes such as equity mutual funds, stocks, fixed debt instruments, gold, real estate or cash in some ratio as per your priorities of goals. So, investing all of your money in one type of asset class, whether it’s stocks, bonds, fixed deposits or cash, can leave your portfolio vulnerable to deep swings in value or cause you to miss opportunities for growth. But spreading your investments in a deliberate, strategic way among stocks, bonds and cash may help reduce the effects of various market swings while providing you with the opportunity to benefit when particular areas of the market perform well.
Let us understand how asset allocation works
Although no particular investment methodology can guarantee success, the reason asset allocation can potentially lower the risk, or volatility, of your overall investment portfolio is something called asset correlation. If one type of asset tends to move independently of another over short periods of time (though in the long run you hope they all go up), the two are relatively uncorrelated.
To help better diversify your portfolio, invest in a pair of assets that tend to move in opposite directions in the short term. This low correlation—on zigs while the other zags—can potentially reduce risk substantially while positioning your investment portfolio for the opportunity to pursue relatively higher returns over the long term. This underscores the importance of choosing an optimal mix of assets.
Here’s a hypothetical example of the value of correlation: Ajay has invested of Rs1 lakh, with Rs50,000 in a diversified equity portfolio and Rs50,000 in a debt portfolio. The stock market falls sharply while debts hold strong. By year-end, the equity portfolio loses 20% (Rs10,000 loss for Ajay), while the debt portfolio gains 10% (Rs5,000 gain for Ajay). Overall, Ajay’s portfolio drops Rs5,000 in value.
Meanwhile, Vijay has all of his Rs1 lakh invested in the equity portfolio and consequently loses Rs20,000. Ajay comes out with Rs15,000 ahead of Vijay because the gain from his debt fund allocation has partly offset his equity fund loss.
This occurs because the equity and bond positions in this case exhibit negative correlation. Most importantly, Ajay may be better positioned to rebalance (as discussed later) so that he could have the opportunity to benefit from the possible trend reversal of equities. Again, this is a hypothetical example describing correlation. The returns illustrated are not indicative of any particular investment’s performance or yield.
In addition, you need to consider your risk tolerance, or the amount of account balance fluctuation you can stomach. The young investors with heavy stock exposure may worry about how their investments will hold up to short-term market swings. If so, they might reduce their exposure to stocks while increasing their allocation to debt and cash. At the same time, they’ll likely need to increase the amount; they invest to compensate for the slower growth they might expect from their more conservative, fixed-income investments.
When you evaluate your asset allocation, remember that the big picture, how all assets work together to help you pursue your overall goal over time, is what matters most? Poor short-term performance in a particular equity fund or asset class may be disappointing, but perhaps it should not be looked at in isolation.
Think about a student who fails in a mid-term exam or an employee who performs poorly on one assignment. That person’s performance shouldn’t be judged on that one item, but rather on a full year’s effort and results, taking into account many other factors, and providing the opportunity to improve or excel in other conditions or situations.
Rebalancing the portfolio
Over time, market changes can shift your portfolio’s asset allocation away from your original targets, creating additional, unintended and unnecessary risks: Should your portfolio stray too far from its allocation target, you could be exposed to more or less risk than is warranted by your situation. The act of bringing your assets back to their target allocation is called rebalancing.
If your allocation has shifted, you can choose simply to direct new contributions to the types of assets that are underrepresented in your portfolio. For example, if stocks exceed your targets but bonds fall short, you could consider devoting new investments to bonds until you feel you are back in balance. Alternatively, you might consider selling some of the over performing assets and use the proceeds to invest in the laggards, though this may have tax implications.
When should you rebalance?
A common rule of thumb in the industry is to consider rebalancing once or twice a year. While the answer for you may be as simple as that, it’s more important for you to understand the logic so you can figure out what frequency is right for you. Ultimately, you may want to consider rebalancing more frequently or less frequently to help keep asset allocations consistent with your goals and your own level of comfort while also weighing the cost of doing so, including transaction fees, taxes and the nature of your account.
How PrudentFP can help?
Prudent financial planners can help you build an appropriate asset allocation strategy for your particular situation. Take advantage of our online platform help find the right mix of equity mutual funds, debt funds and gold for your particular situation.
If you are a Prudent financial Planners client, we can help you determine an appropriate asset allocation for your financial goals, along with steps to bring your current portfolio in line with that allocation.
Keep in mind that asset allocation, rebalancing and diversification does not ensure a profit or protect against loss in declining markets. Not all asset classes may be suitable for all investors. Each investor should find the appropriate mix of asset classes based on his or her goals, time horizon, liquidity needs and risk tolerance.
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