Asset Allocation – Why and How

The recent gains in precious metals – gold and silver – made headlines when they jumped to their all-time highs. While buying in them still remains consumption-heavy in India, certain financial investors could have felt a FOMO (fear of missing out).

When the Nifty 50 and Sensex -- the most widely used benchmarks for equities in India -- are clocking in robust gains, it evokes similar emotions. 
 

What we are experiencing around us is essentially an investor’s desire to be invested in the right asset class at the right time. 
 

Historical evidence has shown that uncertainty, of most kinds, leads to investors moving from riskier assets such as equities to relatively safer assets such as fixed income and gold. To that extent, it has been observed that when equities are outperforming, returns in gold tend to be muted.     
 

The last few weeks, though, have proven to be contradictory, as both equities and precious metals have done well in the local financial markets.
 

What this highlights is that even though it may be possible to anticipate how financial markets and asset classes are likely to move based on previous instances, one can never quite be sure. And the way to mitigate this is to remain invested across asset classes in a manner where their performance complements each other to get the best possible returns for investors.
 

This, in essence, is asset allocation – where investors are spreading their investments across asset classes in a way there it helps them meet their financial goals while cutting down the risk for the portfolio to the least possible in the event of a downturn.
 

Apart from shielding your investments from the risk of exposure to a single asset class, asset allocation can be used to customize your investments to be in sync with your financial goals, and the tentative time when you will be needing these funds.
 

Another thing to keep in mind would be that asset allocation will vary as per each individual or family’s requirements, and to that extent, there is no standard template that investors must follow for asset allocation.
 

For instance, the investment pattern and asset allocation of a 26-year old without any major fixed expenses will vary from that of a 36-year-old who is the sole breadwinner of their family and ends up spending a major chunk of their earnings on non-negotiable expenses.
 

Among the key differences for the two investors here would be the percentage of funds that can be used for investment purposes, their risk appetite and the time horizon they have for their financial goals.
 

Let’s understand this better.
 

The 26-year-old investor could just be starting off on their investment journey, and has an aggressive risk-taking appetite given that they do not foresee the need for using these savings in the next three-five year period.
 

The individual is, hence, drawn to put in most of their savings in equities and related instruments, with a view that this asset class could outperform given the time horizon. 
 

The 36-year-old, meanwhile, is spending as much as three-fourth of their salary on fixed expenses which include EMIs, education expenses, healthcare, utilities and some discretionary spends each month.
 

Upgrading to a bigger car in about three years, keeping up with the continuously rising costs of education, and a bigger medical cover for his family are this individual’s key goals from a three-five year perspective.
 

This individual is planning to keep a major chunk of their investments in fixed-income instruments, which will help with periodic payments to keep up with expenses, while keeping the capital relatively intact. A small portion has also been earmarked for investment in equities from a 7-10 year time horizon, which can be used for pre-payments or a foreign vacation. He is also planning to keep about 5% of his investments in gold and silver, to benefit from their upcycle.
 

These two case studies show how asset allocation varies across age groups, priorities and financial goals.
 

STRATEGIES FOR ASSET ALLOCATION
While it is important for investors to keep their portfolio well-defined with asset allocation as per their requirements, equally important is to periodically review it to make sure that the portfolio is performing in line with one’s view, and if not, to make the necessary changes.
 

Investors should ideally check the performance of their portfolio every three-six months to see how each of their invested asset classes have performed, and then take a call on what changes need to be made. 
 

1. What are the changes we are looking to review in this period?
   Changes in macroeconomic, company-specific conditions
   - An unexpected, adverse event may make a certain asset class or a specific company not suitable for your portfolio based on your requirements, and these need to be addressed
2. Weightage-based asset allocation
   - The outperformance or underperformance of any asset class vis-a-vis the performance of your overall portfolio will lead to a change in its weightage as compared to what you have originally planned for, making it skewed to a particular class.
3. Tactical changes
   - These are generally calls taken for the short-term where you may choose to buy or sell an asset or a security only for its expected performance in the short-run.
    

For instance, if an investment in equity was expected to yield around 15% return each year, and has surged by 60% in two years, investors can consider taking some profits off the table. This will have two benefits – one is that the proportion of each asset class in the portfolio remains in line with your view, and the second is that certain profits have been taken off the table. This is an example of weightage-based asset allocation, and these profits can then be re-directed to other asset classes or be used for expenses.
 

When planning finances, asset allocation is one of the best tools that an investor can use to ensure that their portfolio is not-only well-diversified, but is also customized to meet their financial goals. Happy investing!