Investment experts always emphasize the importance of asset allocation. Since it is impossible to predict market trends, it is always better to rely on a safe investment strategy. There is no better investment strategy than asset allocation.
What is asset allocation?
Asset allocation is the process of allocating your investment funds among different assets like equity, debt, gold, and cash according to your financial goals. It helps to balance risk and reward and optimize the return from portfolio.
Worst decisions are taken at the best of times
Investment history tells us that bad investment decisions are taken at the best of times. At the peak of a bull market many investors, particularly the newbies, rush to the market and invest recklessly in equity, even when the markets are overvalued. Actually, overvalued, and euphoric markets should caution investors to move some money away from equity to safer assets like fixed income and gold. Similarly, at the trough of a bear market, when equity valuations are attractive, many investors sell equity because the sentiments are negative and there is widespread fear in the market. Actually, when valuations are attractive, investors should be accumulating stocks.
Asset allocation strategy is person-specific
Asset allocation strategy will vary from person to person. It will depend on an investor’s age, financial goals, risk-tolerance, and investment time horizon. Let me elaborate. Age is a very important factor in determining asset allocation. Normally, young people will have a longer time horizon for investment than elderly persons. Also, young people will have a higher risk-appetite than the elderly. So, there is a general principle which says that a person’s equity investment should be 100 minus his age. That is, a 30-year-old investor can have a 70 percent exposure to equity while a 70-year-old should limit his equity exposure to 30 percent. This is only a general principle and need not apply to all. For instance, it is possible that a very rich old person may have a high risk-appetite and may prefer a high exposure to equity. Also, it is possible that a young person with limited income and high committed expenses, will have a low risk-appetite and may prefer a lower exposure to equity. Therefore, risk appetite/ risk tolerance is important.
An important factor deciding asset allocation is the financial goal of the investor. Financial goals vary from person to person. Goals can be short-term like raising enough money to go on a foreign tour. Goals can be medium-term like raising enough money to make down payment for buying a car. Investing for retirement is a long-term financial goal. So, investment should be fine-tuned for the realization of the financial goals. A short-term investment for, say, a period of three years should not have any exposure to equity, even if the investor is young. By the same logic, a long-term investment should have a high exposure to equity even if the person is not so young.
Another important factor determining asset allocation should be the market situation. That is, whether the market is overvalued, or fairly valued or undervalued.It is difficultto say at a given time that the market is overvalued or undervalued. Even from a point of overvaluation, the market can rise further and move to a stage of euphoria. Similarly, even from a stage of undervaluation, the market can fall further and move to a stage of panic. Such trends have happened in the past and will happen again. Even then, we can make a reasonable decision regarding investment based on established norms of valuations. If the important investment metrics like Price Earnings Ratio, Price Book Value Ratio and Market cap to GDP indicate overvaluation, investors can sell a part of equity and switch to fixed income and gold. The opposite strategy should be tried when the valuation parameters indicate that stocks are attractive. That is, when the market is in bear territory and valuation parameters indicate that equity is cheap, investors can move money from fixed income and gold into equity. Money can also be moved to cash/money market instruments to be deployed at the opportune time.
Equity portfolio rebalancing can be done within market caps, too. Sometimes, large-caps will be expensive and mid and smallcaps will be cheap. During a sharp market correction, mid and small caps will be heavily sold, rendering their valuations attractive. This will be a favorable time to switch to mid and small caps. Similarly, during bullish euphoric times, when newbies chase mid and smallcaps, their valuations will become expensive. This will be a good time to switch from risky mid and smallcaps to the safety of largecaps.
Geographical diversification can be another form of asset allocation. Geographical diversification involves investing across countries. Now it is possible to buy foreign stocks. An easy way of doing that is to invest abroad through mutual funds. It is very simple. Investors can invest in mutual funds which invest in foreign stocks.
