Investment planning: four cardinal rules of asset allocation

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When you build a portfolio with asset classes that have a low correlation between them, the higher returns from one part of your portfolio will offset the losses from another part when the markets fall.

By Hemanth Gorur

Asset allocation is a way of determining how much to invest in each of the four main asset classes: stocks, debt, commodities and real estate. Each of these asset classes has its own advantages and disadvantages, and thus investor preference for asset classes can differ significantly.

However, there are certain asset allocation rules that no investor can ignore. Let’s see what these rules are.

Rule 1: Invest in at least three asset classes

Suppose you have a sum of Rs 10 lakh to invest. What happens if you invest the entire sum in a single asset class, for example stocks? If stock markets fall, your entire investment depreciates. This can happen regardless of asset class as long as you invest in only one asset class.

To avoid this scenario, you are better off investing in a portfolio of at least three asset classes so that if one or two asset classes experience a downward price trend, the other asset classes will act as a buffer and prevent your portfolio from taking a downgrade.

Rule 2: Maintain a low correlation between asset classes

Rule 1 only works if you follow rule 2. In the previous example, if you had distributed the `10 lakh on physical gold, ETF on gold and debt funds only, and if the markets had risen, you would have lost an opportunity for much higher returns. Gold and debt are defensive asset classes and are unable to take advantage of bullish market sentiments like stocks can. They are considered to have a strong correlation between them.

The reverse is also true. When the markets crash, and if your only investments had been in stocks and real estate, your entire portfolio would have taken a hit. This is again because stocks and real estate have a higher correlation than stocks and gold for example, as both are negatively affected by bearish market sentiments. However, when you build a portfolio with asset classes that have a low correlation between them, part of your portfolio would earn higher returns when markets go up and the other part of your portfolio would minimize losses when the markets go down.

Rule 3: Periodically rebalance the portfolio

The only way to grow your investments consistently over the long term is to buy low and sell high. Consider a portfolio of 10,000,000 invested in stocks and debt in a 70/30 ratio. Portfolio rebalancing involves keeping your portfolio at the target ratio of 70:30, regardless of market movements. Suppose stock markets fall 10% while debt markets rise 1% over the next year. Your portfolio ratio has increased to 68:32. By applying portfolio rebalancing, you must restore the target ratio of 70:30 by selling debt and buying stocks. In effect, you have “bought low” in equity markets and “sold high” in debt markets.

Conversely, if stock markets rise 10% and debt markets fall 2%, your portfolio ratio becomes 72:28. To restore it to 70/30, you need to sell stocks and buy debt. So, you have “bought low” in debt markets and “sold high” in equity markets.

Rule 4: Move from yield maximization to yield protection

The danger of maintaining a static asset allocation is that as your financial goals or retirement years approach, the equity portion of your portfolio may suddenly lose value due to adverse market movements. To avoid this, you can gradually reduce your exposure to equities and increase your exposure to debt accordingly over the last 5-10 years before your financial goals expire or your retirement years begin, because debt is considerably safer than stocks.

While investment rules are there for a reason, the judicious application of those rules is in the hands of the investor, where discretion and enterprise are required in equal measure.

The writer is the founder, Hermoneytalks.com

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