We have gone through some exciting wealth preservation strategies in our pursuit of Financial independence so far. Taking Insurance: this lets us retain a bulk of the wealth in the event of an unforeseen mishap. Saving money outflows directly correspond to growing money. In our pursuit in this direction let us see how to grow money further.
Asset allocation is how you divide your investments between different asset categories like Equities, Debt, Gold, Real Estate and Cash. Again here, there is no one-size-fits-all and is usually tied to a person’s risk tolerance, personal and financial situation and many other factors which in combination determine one’s Investor profile. Asset allocation is probably one of the simplest tools readily available for investors that it is even termed as ‘Almost a Free Lunch’ in the investing world.
Asset allocation is by far the most important part of anyone’s investment portfolio. In a study in 2000, Kaplan and Ibbotson inferred that almost 90% of the Portfolio variability is directly attributed to Asset Allocation. If this were true only 10% of a portfolio performance is due to the individual holdings while 90% of it is determined by how one has allocated their money. This goes to show the importance of asset allocation.
It is a well known fact that Stocks and Bonds move usually in opposite directions. During the onset of a bear market due to the volatility in equity returns investors start flocking to Bonds. Hence as the appetite for equity starts to fall (along with its return) the yield on bonds go up. Thus if a portfolio is composed of Stocks and Bonds then when the stock component falls the bond component gains (not equally!) thus protecting the downside. It is very much required to hold debt in almost all portfolios, as studies have clearly shown. This forms the crux of Portfolio Management.
Let us say someone started with a 60% Equity and 40% Debt allocation at some point in time. Over a period of time since both equities and debt will often provide different returns the asset mix will shift. Every once in a a while (atleast one a year) one has to do what is called as ‘rebalancing of a portfolio’ to bring the portfolio back to its original asset allocation. If the Equity portion of a portfolio has gained one sells some equity and moves it to Debt to retain the original allocation and vice versa.
Determining optimal Asset Allocation
There is no direct answer to this. A combination of primary factors below will allow one to arrive at optimal asset allocation:
Risk tolerance: The lower one’s risk tolerance the lower their equity allocation.
Financial situation: If all investment evaporates can one still keep up their standard of living. How long can they survive?
Time horizon: The longer time one has toa financial goal the more equity one can hold.
A thumb rule is that the allocation to Debt must be the same as your age. A 30 year old can have 30% Debt and 70% Equity while the Debt exposure will need to be about 60% for a 60-year-old person. REMEMBER: This is just a thumb rule.
Research based historical inferences
A lot of studies have been undertaken in much of US and Europe to prove that Asset allocation significantly determines the wealth generated over a long period of time. I have attempted here to do a research on the Indian markets to confirm whether such a theory holds good.
- I have created a group of portfolios ranging from 100% Equity to 100% Debt and compared the performance of the portfolios during a period of time. I have ignored Real Estate and Gold for simplification purposes.
- The period of study is this millennium, from 3-Jan-2000 to 9-Dec-2011.
- Nifty closing for this period has been taken. It is assumed that the rebalancing is done once a year on Dec 31st. The Initial allocation alone happens on 3-Jan-2000.
- The average Bank FD return in India for this period is assumed to be 8% (Range: 7.25% to 11%)
- Taxes and Brokerage expenses/Investment fees have been ignored in the study
- Rebalancing: A Hypothetical amount of INR 100,000 is assumed to have been invested on 3-Jan-2000. With a 60/40 Equity/Debt allocation one starts with INR 60,000 in Equity and INR 40,000 in Debt. For easier calculation purposes I have declared equity units to be allocated (like an ETF). At a Nifty closing of 1591 on 3-Jan-2000 there are 37.68 units of Nifty available. At a Nifty closing level of 1263 on Dec 31, 2000, the Equity portfolio has fell from INR 60,000 to INR 47615 (Which is 37.68 units * Closing value of 1263). The Debt portfolio at the end of that year @ 8% growth is INR 43,200. The overall portfolio value now is INR 90815. This is again split into 60/40 between Equity and Debt. It is assumed we are able to reinvest Debt at 8% throughout this period.
- The rebalancing process continues at the end of each year until Dec 9, 2011, the time the research results were being collated
An allocation of 100% to Nifty and 100% allocation – Both have underperformed several of Asset allocation models as outlined in Exhibit 1. This must ring a bell for 2 classes of investors:
- The overzealous who want to invest 100% in Equity
- The ultra conservatives invested in full in Debt (like FDs)
Both these models have underperformed a simple Index fund + FDs combo by about 100 to 300 basis points at the 70/30, 60/40 allocations. As diversification from 100% Equity starts to 90/10 and beyond the return of the portfolio increases steadily, peaking around a 60/40 allocation and then falling off. Even a 25% Equity allocation + rebalancing has marginally beat the market. [NOTE: It is not to be construed that 60/40 is the ideal allocation]. The important idea to take away from here is that Asset allocation + Rebalancing plays a significant role in wealth generation.
The counter-argument goes something like this: Some diversified Mutual funds have easily returned about 15+% CAGR over a period of time So would it not be better to invest in 100% Equities and just buy such sound Mutual funds and sit. There are 2 problems here. One is, since past performance is not an indicator of future performance, it is difficult to zero in on a fund that can outperform the market so consistently. Again, such MF portfolios are likely to be more volatile than a balanced portfolio. Hence, however convinced one is about the fund selection, if one has to experience wild swings over a period of time with the Portfolio swaying big time say, -50% or more, it is highly likely someone is going to exit the fund altogether as has happened in the recent falls of Jan 2008 and Jan 2011 (and in any fall, historically, across countries). These two are powerful reasons for diversification and asset allocation.
I have attempted a similar study like the one we saw in the Nifty example just above – this time rebalancing with one of the Top diversified Mutual Funds in India, HDFC Top 200. Many funds that were on the same pedestal as this fund for a significant part of the decade have rolled off subsequently, just showing that a good fund selection is very difficult and risky more so to be fully invested in.
NOTE: This is neither an endorsement for HDFC Top 200 scheme nor a denouncement + There is no guarantee such returns can necessarily be sustained in the future (Disclosure: I have a SIP running in HDFC Top 200-Growth since Jan 2010).
The results are not vastly different (see Exhibit 2) in that a rebalancing at 90/10 allocation still marginally beats a fully invested portfolio in the MF over a period of 11 years reinforcing that a Portfolio rebalance still can beat a full allocation to equity.
Though a detailed study on the impact of taxes on bond yields and MF fees and expenses has not been carried out a cursory plugging in of the numbers in the attached spreadsheet will help establish that the results are not too different in that the yields spreads between a full allocation to equity and a rebalanced portfolio will decrease on one side and that every 100 basis point (1%) increase in the Bond/FD yield will make a larger set of Portfolio Asset Allocations beat both the Market and diversified Mutual Funds in general.
Closing note: Asset Allocation is such a powerful tool with which it is possible to join hands with any of the best performing MF scheme and even beat it over a period of several years by combining the MF with Debt and rebalancing at least once a year. This very simple tool can be used to protect wealth already generated by moving the equity earned income to Debt and also vice versa, by purchasing more of Equity when the markets are beaten down. No wonder this strategy is referred to as ‘Almost a Free lunch’ because an investor has the complete choice in determining their allocation no matter what the markets do and where the markets head.
The next step in this exciting journey of growing money is to ensure we arrive at an Asset allocation, following the thumb rule to begin with and stick to it and rebalance – increasing your chances manifold to grow your money!
About the author: Anand Balakrishnan is a CFA Level II candidate and a Certified Personal Financial Advisor (CPFA). He also contributes at Seeking Alpha – http://seekingalpha.com/user/689315/instablog.
Sources/References: http://www.nseindia.com/ and www.hdfcfund.com. Market emotions image sourced from http://www.arborinvestmentplanner.com/.