If you believe that it’s the security or fund selection that is crucial to your financial success, you might be in for a surprise!
Asset allocation provides stable risk-adjusted returns. If you get your asset allocation right, your portfolio will take care of itself. Most people search for the best mutual funds and try to invest when market valuations are cheap. They think these are the most important factors for getting high portfolio returns.
In reality, asset allocation is the most critical factor. It can help you to get stable risk-adjusted returns in the long run. The first step is to decide how much you will invest in different asset classes. This includes equities, debt, gold and real estate.
Asset allocation is much more important than choosing top-rated mutual funds. It is also more important than investing when markets are cheap.
What is asset allocation?
Asset allocation refers to how much money you invest in different types of assets. This includes equity, debt, gold and real estate. For mutual funds, it relates to the division of funds between equity and debt mutual funds.
We can divide equity mutual funds into different categories. Some of these are large-cap funds, mid-cap funds, small-cap funds, and multi-cap funds. There are also large & mid-cap funds, ELSS funds, sectoral funds, value funds, etc.
We can divide debt funds into liquid funds, ultra-short funds, and short-duration funds. There are also medium-duration funds, long-duration funds, corporate bond funds, etc.
We can divide hybrid funds into conservative hybrid funds and balanced hybrid funds. There are also aggressive hybrid funds, dynamic asset allocation funds, arbitrage funds, etc.
Each of these categories has different risk and return characteristics. You need to pick the right mix of funds based on your goals, age, return expectations, and risk tolerance.
Also read: Asset Allocation Strategies for Investment Planning
Why is asset allocation so important?
A study conducted in 1986 examined the effects of asset allocation on pension funds. It showed that asset allocation accounted for more than 90% of total return variation. Market timing and stock selection played a minimal role.
Asset correlation measures, how different assets move in relation to each other. Correlated assets tend to move up or down at the same time. Assets that are not correlated tend to move in opposite directions. When one goes up, the other tends to go down.
Investing in non-correlated assets reduces risk and increases returns in the long term. Diversification across different asset classes helps to reduce volatility.
The level of correlation between different asset classes can change. This seems to have happened after the financial crisis of 2008. Since then, many uncorrelated assets have started moving up and down together.
Asset allocation in unpredictable market conditions
It isn’t easy to invest at times when global and local uncertainty is very high. A mix of diversified equities and debt can provide higher returns with lower risk.
Diversification across asset classes, sectors and regions acts as a hedge. It can protect investors during unpredictable market movements.
Mutual fund investors need to find the right balance between equity and debt. While it can be tempting to invest all your money in aggressive equity funds, this can be risky. Equities provide high returns, but they are volatile and risky.
Debt is safer and less volatile than equity, and it provides decent returns. However, at times, debt investments may not even beat inflation.
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How to decide on your asset allocation strategy
You can invest a fixed percentage in equity and put the rest in debt. The debt-equity ratio depends on your return expectations and risk tolerance. Rebalance your portfolio if the equity or debt part exceeds the planned allocation.
Decide on the debt-equity ratio based on your age. When you are young, you can take more risk by investing more in equity. As you grow older, you can reduce your equity exposure and move your money to debt.
You can deduct your age from 100 to do this. For example, if you are 35 years old, you can invest up to 65% in equity and 35% in debt. When you reach 60, you can invest 40% in equity and 60% in debt.
You can have separate investments for different goals. For short-term goals, invest more in debt and less in equity. For long-term goals, invest more in equity and less in debt. For example, if you need the money within 3 years, consider investing in debt. If you need the money after Seven years, consider investing in equity.
Dynamic asset allocation involves changing your allocation based on market valuations. When markets are expensive, reduce equity allocation. Increase the equity allocation when markets are cheap. Use the price-to-earnings (PE) ratio and price-to-book (PB) ratio to assess valuations.
However, it isn’t easy to time the markets and alters allocations based on valuations. It can also be risky. Portfolio rebalancing involves paying exit loads and short-term or long-term capital gains tax.
Also read: Permanent Portfolio: Asset Allocation made easy
Using hybrid mutual funds to manage your asset allocation
Hybrid or balanced mutual funds invest in a mix of equity and debt. When the markets are expensive, the fund manager reduces equity and increases debt. When the markets are cheap, the fund manager increases equity and reduces debt. The investor doesn’t have to worry about exit loads or capital gains tax.
Conservative hybrid mutual funds invest 75% – 90% of their assets in debt and the rest in equity. They offer stable returns but don’t qualify for tax benefits allowed to equity mutual funds.
Balanced hybrid mutual funds invest 40% – 60% of their assets in debt and the rest in equity. They are less volatile than equity mutual funds but don’t qualify for tax benefits allowed to them.
Aggressive hybrid funds invest 65% – 80% of their assets in equity and the rest in debt. This allows them to qualify for tax benefits allowed to equity mutual funds.
Dynamic asset allocation mutual funds invest in a mix of equity and debt. The fund manager keeps altering the debt-equity ratio. The equity exposure can vary from 30% to 80% or even more. In most of them, the combined equity and arbitrage exposure remains above 65%. This allows them to qualify for tax benefits allowed to equity mutual funds.
Conclusion
Asset allocation is the most important determinant of portfolio returns. It is much more important than timing the market or choosing the best mutual funds. Diversifying across non-correlated assets helps to reduce risk and increase returns. Create an asset allocation strategy that suits you. The right mix of debt and equity will provide good returns with lower risk and volatility in the long term.