Importance of Asset Allocation

It is well-known that the key to long term wealth creation is through the right asset allocation. A lot has been written, discussed and debated as to what is the right asset allocation for individuals across different life cycles and different types of asset classes ranging from physical assets to financial assets. Real estate and gold are a predominant asset class in most Indian households and there is little or no scientific allocation process followed for the same. Also given that, alternate asset classes like private equity, REIT’s, commodities and art are out of bounds for an average investor, I would limit the scope of my discussion on asset allocation to financial assets.

It is observed that very few investors practice scientific asset allocation for their investments. A large portion of the investments made in equities or debt is driven by the performance of the respective asset class over the previous 2-3 years. For instance, a lot of money was invested in bond funds in 2003–04 on basis of high returns on the previous 2-3 years. Similarly, investors chose to invest large sums of monies in equities in 2007–08 driven by high past returns.

Given the disillusionment in equity returns over the last several years, bulk of the financial investments has gone to Debt Mutual Funds (mostly FMP’s and Accrual funds) and tax free bonds over the last 12 months. Also to take benefit of the high interest rate environment, many investors have significantly skewed their asset allocation towards debt.

I would recommend a simple asset allocation process to investors. Prepare an asset allocation plan based on your risk profile and goals.

To achieve long term goals like children education and marriage necessitates an allocation to equities. However, only that portion of investments should be allocated to equities on which you are able to withstand a 30–40 per cent notional loss in the short term.

Review the plan at least once a year and rebalance.

It is observed that some investors do prepare an asset allocation plan; however they abandon it knowingly or unknowingly depending upon the movement in a certain asset class and the immediate investment environment. For e.g. If equities under perform over a long period of time, the asset allocation becomes debt heavy. Also, fresh investment moves into debt given the poor past returns of equities. These lead to imbalances which are harmful to your goals in the long term.

Define a core asset allocation (to equity and debt) and tactically change it depending on the view on macroeconomic factors.

It is important to have a core allocation to equity given the good prospects of the Indian economy going forward. Allocation to equity can then be tactically increased depending on view on economy, corporate earnings, etc. Similarly, it is also important to take advantage of opportunities in form of Tax Free Bonds, FMP’s with indexation benefits, etc which are not always available on-tap.

My recommendations on asset allocation for an investor with a moderate risk profile:

Equity
30 – 35 per cent (core allocation). These could include a mix of diversified equity funds with large-cap bias, mid-cap funds and international funds

Debt
40 – 50 per cent (core allocation). These could include a mix of tax free bonds, FMP’s, short term bond funds, gilt funds, accrual funds etc

Tactical allocation
15 – 20 per cent should be set aside in Liquid Funds/Ultra Short Term Funds for tactical allocation to equity depending on the view on equities. These could be allocated to diversified equity funds; mid or small cap funds or thematic funds (such as Infrastructure Funds, etc). Also, in the event of a fall in interest rates, Tax Free Bonds can be sold for a gain and allocation can be increased to equities.

The equity component for the conservative or aggressive investor could be either 10-15 per cent higher or lower. In my opinion, investors should stick to their strategic asset allocation plan and not to deviate by more than 10-15 per cent. Recent experience suggests a heavily skewed allocation towards debt which to my mind is difficult to reverse (if large allocations are to FMP’s or tax free bonds (smaller issue sizes). Thus, a proper asset allocation plan with active diversification will help generate higher inflation adjusted returns and lead to secure wealth building.

Milind Barve is the Managing Director, HDFC Asset Management Co. Ltd. *The views expressed here are the author’s views.