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.
Rebalancing
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:
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Risk tolerance: The lower one’s risk tolerance the lower their equity allocation.
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Financial situation: If all investment evaporates can one still keep up their standard of living. How long can they survive?
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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.
Research Background
- 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
Key observations
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/.
justgrowmymoney 
Please correct the following :
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 40% for a 60-year-old person. REMEMBER: This is just a thumb rule.
Replace 40% Debt with 60% Debt for 60 year old person.
Anil – Appreciate pointing this out. This stands corrected!
I agree with every thing you have said here. My only question is regarding frequency of rebalancing. You have said atleast once a year. My feeling is that rebalancing more than once a year may not be practical.Most of the time we invest in fixed deposits with durations of more than one year based on the highest interest rates available. In ELSS funds there is a lock in period of three years. We have to remain invested in diversified equity mutual funds for more than one year so that we don’t have to pay taxes. I would like to know the strategy for rebalancing when one has invested only in bank fixed deposits and diversified equity mutual funds.
Anil – When I mentioned the frequency of rebalancing to be atleast once a year I actually meant “Do a rebalance around the 1 year mark, not every 2 or 3 years”. I understand the wording was ambiguous.
There are 2 scenarios A) Stock markets/Diversified MFs give stellar/positive returns B) Stock markets/Diversified MFs give a negative return. So in scenario A (assuming capital of 1 Lac) if we start with 60/40 allocation and the MF portion has grown to 80 and FD portion grows to 50 we have a total of 80+50=130. We need to take into consideration that we pump in fresh money every year, say another 1 Lac. So your total in hand is 130 (from last year) + 100 (fresh investment). Adjust this fresh investment in such a way that your original 60/40 is maintained. So you wont be necessarily be forced to sell MFs within 1 year and long term FDs.
FDs again must be created in a ladder-like fashion, like SIPs. Instead of a bulky Rs. 60,000 FD investment, for example, one can invest 20,000 over a 3 month period to build a bond/FD portfolio. If you have to ever break a FD you may choose to just break 1 FD of 20,000 (as need dictates) so you pay lesser penalties overall.
By laddering on FDs the portfolio will never be in a fixed ratio for long times. You will anyways invest fresh money in SIPs and not in one-go. So the equity portfolio will also get modified every month, almost. Thus the asset allocation is merely a benchmark to head towards. ELSS’ are most probably going away, thanks to DTC, so that worry can be shelved. Except for the initial time someone sets this up an allocation the portfolio will see-saw througout the year due to SIPs and laddering. We set that right around the end of the year. As long as the original allocation does not diverge big time from the target allocation there is no worry.
As a side note: If there is a sudden drop in the market and the allocation turns from 60/40 to 30/70, perhaps a tactical re-allocation can be made here. But this is the equivalent of timing the market and several portfolios are better off not attempting something like this!
While investments in equity mutual funds are done mostly via SIP route, the same can not be said of investments in debt instruments. Most people allow their savings to accumulate in their savings bank account and think of having a fixed deposit only when balance has reached a level of around Rs 50,000/-.Then they book fixed deposit for a duration which offers maximum rate of interest. Laddering is no doubt a good concept but it requires a lot more work.Flxideposits with switch in and switch out can be another option but you do not always get the best interest rate in that.
Very nice article… Very informative!
You have made your Research with Nifty and Indian interest rates.
But let’s take the case of US and DOW Jones.
Dow is closer or sometimes lesser to what it was in 2000
ANd u know the rreturns of Bond market.
Once Indian market start behaving that way where to invest.
Every one say stock market is for long term…believe 11 years is enough…
Subbu – Agreed with the returns on the Dow. Japan’s Nikkei hit 38,000 levels in 1989 and is still now reeling under 10,000 – for over 22 years now. Both these markets returned atronomical returns until 1990s and 2000 – as long as they were on the growth trajectory: US from WWII onwards and Japan a few years after that.
India is precisely on that trajectory today as there is so much growth left. We should have very good market returns for the next 20-25 years. However post that our markets would return as much as most of the developed markets do today. Bond returns are a function of the borrowing rates set by central banks which is again driven by Inflation among several other factors that explains why the bond yields are so low in the developed world.
Once Indian markets get to these levels it will be definitely be difficult to sustain higher returns. Even during those points it will help to have an Asset allocation plan because the returns in some years when high will propel the overall portfolio and when you rebalance you protect the gains. That explains how a handful of funds still have returned some positive alpha in the US in the past decade. As long as the India growth story unfolds ride the waves and lets worry about future returns after the next 10-15 years if not 25 years..
I agree.
Anand Sir – How is lumpsum investment in Mutual funds compared to SIP? I understand SIP brings more discipline, but few people suggest lumpsum investment as well. Whats your call on this. Thanks.
Hi Anurag
SIP or Lump sum, this is a subject of interesting debate. I agree with you that the most important advantage of SIP is that it brings discipline to your investing.Most of us are guided more by our emotions than by cold logic while making important investment decisions.This results in avoidable mistakes.SIP takes emotions out of our investing.
But SIP is no more a simple mode of investment.Many fund house have started tweaking SIPs.These tweaked SIPs are based on the principles of buying more when markets are down and less when the markets are up & buy low sell high.So in a sense they are trying to do the same thing which an investor is tempted to do that is investing more by making some lump sum investments when the markets are low.
The main advantage of traditional SIPs is that you are not trying to time the market.But by tweaking SIPs we are trying to time the markets.When we make lump sum investments we become a hostage of market timing.If we are able to time the market correctly that is investing when the market has bottomed out we can make substantial gains when the market recovers.But if we are not able to time the market correctly and after we make a lump sum investment there is a substantial correction in the market then we will take a very long time break even on our lump sum investments.
So in a nut shell all investors irrespective of their level of financial literacy can safely go for traditional monthly SIPs at all times.Informed investors who are skilled enough to read the markets correctly can go for lump sum investments when markets bottom out.
Anurag – I think Anil pretty much summed it up. The classic SIP model alone works properly across market cycles. The problem with lumpsum is we dont know what the markets would do next. If markets are at 17000 levels today we may feel comfortable pumping in lump when it gets to 15000 levels. What if the markets falls even further to 13000 levels. A lumpsum at that point is even more attractive. To take the timing and emotions out carry out a regular SIP. What I personally do is [APART FROM THE REGULAR SIPs] on ANY day the markets falls over 2% I go and pump some extra cash in the MF schemes I have invested. It will be as much as a monthly SIP amount sometimes or more but never a huge amount. This way money grows via SIP but each of my additional purchase is ‘theoretically’ cheaper than the previous day. This helps me to remove any timing needed (as regular SIPs anyway continue). If you have really large amount to invest put them into a Debt fund and instead of a SIP do a STP, that way your money grows at least around 8-9% (at currrent rates) and you can then move them to your core schemes.
I had read one article of Monika Halan in which she had suggested this strategy of making small lump sum investments whenever the market corrects around 2% and just like you I also followed this strategy for some time.Since I used to make investments on next day most of the times I found that market used to recover and the benefit of low NAV of the previous day could not be obtained.
On days the markets fall 2% or so you got to invest by 3 pm the same day. Barring 1-2 instances the market has usually not recovered big between 3:00 and 3:30 pm the same day. If you are in a different timezone or unable to access the Market it is difficult to implement this. If you have a liquid fund you can just log on and transfer than going thru additional steps of authentication using net banking etc.
Anil and Anand Sir – Many thanks for your comments on this topic. It was very helpful and cleared my doubts. Thanks again for your time.
Anand Sir – I have became your fan by reading your wonderful analysis and explanation to some Mr. Swami on topic “PPF v/s …” on jago investor forum. Where do you post maximum comments, I mean on which site under which section so that I can follow them on daily basis and gain some knowledge? Which city are you based in Sir? Can you please show me as well some guiding light in financial planning world? FYI, I am a close follower of Ashal ji as well and take a lot of advice from himover phone and web chat. He does a brilliant job in financial planning space and that too without any self intrest.
Hi Anurag
There are a lot of people on this planet who try to help others without any self interest.Sometimes we come across them while visiting some blogs.I have found ONE MINT and TFL GUIDE very useful.
Anurag – I do not have a set pattern but I am active both at Jago Investor forum and Investta. If you look at the 5-odd or so articles I have in my blog https://justgrowmymoney.wordpress.com/ that will pretty much make clear what financial planning is all about. First is containing risks – taking Term Insurance, Health Insurance etc. And then the next is growing wealth for financial goals. I will send you a detailed Financial plan template for you to fill out. I will come up with my recommendations based on that. And of course, I do not charge for this service nor would I gain materially with any recommendation I will make.
Thanks again Anand Sir. Please can you send the template to me at annu707in@gmail.com so that I can fill the same and seek your advice?
Sir on a quick note, I have 1 Lakh rupees lying idle with me which I want to park somewhere and obviously get maximum returns, tenure is not an issue, it can be 10, 15 years whatever. Please can you advice where to park this amount ( stocks, MF, Gold, Silver, PPF, FD etc.)?
Anurag – This will depend on what you intend to do with that amount eventually. If this is accumulated for a specific goal which is no more than 2-3 years away you must park this in Short term MFs/FDs and such short term instruments. If this is for the long term how you utilize this 1 Lac will depend on your overall financial plan.
Sir I am still waiting for the financial plan template as mentioned by you. Please can you send it across?
Anurag – I have sent this across to your email address. Please confirm receipt by responding to that email. Thanks!
Hi Anurag
If you consider the time frame of 10 to 15 years then you can expect to get the best returns if you invest in good diversified equity mutual funds. So you can park your money in a bank flexi deposit and initiate SIPs in around two to three five star rated equity funds.Keep on tracking the performance of funds by comparing the returns with index and category average.
Dear justgrowformoney,
I need your service in doing my FP but definitely not for free of cost . I hope you charge me reasonably ( 🙂 just kidding !!.). Already I am running out of the time and got held up / wasted so much of time with another h’bad based Investment firm. Due to this, In fact i was forced to prepare my own templates etc but i realized it takes much more time then i anticipated. Yes definitely i continue spending time on these types of blogs etc but obviously i need to concentrate more on my job now. Hence i request you to take my case and give me a complete financial plan. will send all the details to you what i gave to the other one which is more then enough to arrive the FP. Please let me know the email id and contact no where i can contact you ? i will send all the details and my expectations etc immediately. I would like to finish this in a weeks time and start implementing it immediately.
Cheers
Sowmi
sowmi.narayanan@planetsoft.com
9444150633
Sowmi – I have responded to you over email for the financial plan. Looking forward to hear from you.
Very nice analysis. Drives home the point well.
I am no expert but I would not recommend rebalancing the portfolio each year as a generic advice. This depends on time frame of the goal, risk appetite, initial assumptions made in the calculation etc.
For example my retirement is about 28 years away. I am comfortable with 60% in equity. I made a computation with 10% return from equity and I hope to achieve my goal 3 years prior to retirement after that I intend to switch to debt completely. So i will not significantly reduce equity component until about I pretty close to retirement. Rebalancing is important but to do it 28 time before I retire seems a little too much.
Hi Pattu
I am in complete agreement with what you have said. While it makes sense to review asset allocation every year it is not necessary to do rebalancing every year. In any case asset allocation is not carved in stone and a few percentage point change will not make much of a difference. Moreover asset allocation itself needs periodic review and may change with time. Personally I would do rebalancing only when I see a marked distortion in my asset allocation.
I am in favour of maintaining 30% equity allocation even immediately after retirement and progressively decreasing it with time. In any case what one will do after 30 years can not be predicted now.
Anil – Agreed a few percentage points will not sway the long term returns big time. And yes – It is indeed recommended to have some allocation to Equity even during retirement.
Pattu – Asset allocation and rebalancing are not just academic tools. If one is comfortable with 60% Equity until close to retirement it is still fine. Even then in some years the portfolio could easily sway more than 10% either side. During those times you need not necessarily sell one asset and move to another always. The fresh capital infused each year/month can do much of your rebalancing. 28 times appears to be daunting but an annual review of identifying consistent bottom performers and eliminating them alone can easily achieve the rest of the rebalancing.
Agreed. My calculations show in the final analysis I can take a total loss of up to 15-19% from equity and still achieve my goal.
@Anil: When I said move to debt completely I meant up to retirement. I would like to treat post and pre-retirement strategies as completely independent. Naturally I agree with a good amount of equity post retirement too. Only difference is after retirement one would become a little more sensitive to short term equity performance.
Dear Anand Sir – Please may I request you to reply to my emails sent to you at administrator@justgrowmymoney.com
Regards,
Anurag
Anurag – I just replied to you sometime back. And just address me with my first name Anand, that is absolutely fine 🙂
Dear Anand Sir – I hope you are formulating some financial planning for me. Waiting for your email. No rush, but just curious -:)
Very nice analysis Anand.
Thanks Ram. Do you already rebalance today or plan to rebalance going forward?
Dear Anand Ji,
Could you please send your financial planning template to me @ my e-mail l_tyagy@yahoo.com. Would be grateful to you.
Thanks
lalit
Lalit – I have responded to you. Looking forward to hear from you.
Lalit – The email returned undelivered as the email address was incorrect. Do you wanna recheck the email you published here?
Sorry Anand Ji for the typo. Correct e-mail id is: l_tyagi@yagoo.com
Kindly send it again. Thanks
I dont know what’s happening to my typing skills> Again mistake: here is the final version:
l_tyagi@yahoo.com
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Very interesting blog. A good research done. Can you pls send me the financial template to my mail id—rameshkrk@hotmail.com
Ramesh – Thank You.
I have replied to your email address.
found the article and comments interesting and thought provoking for asset allocation. however it concentrated only two assets, equity and debt, and rebalancing among them. it could be more interesting , if others, gold, realty be included.
i also like to have the financial template from you at your pleasure. thank you.
Bharat – I would limit Gold to about less than 5% in the overall portfolio in most cases and may be marginally more. Realty prices dont have a proper benchmark and there are so many other costs involved etc. so while we can use them for looking at net worth etc. we don’t do any balancing act with them.
Equity and Debt are the financial assets which can be rebalanced to generate wealth.
You can get my financial planning template at https://justgrowmymoney.wordpress.com/downloads/.
your views about gold and realty are indeed guiding for me. i got the financial template from you. i sent my portfolio for makeover suggestions from you. do needful. thank you.
Hi – I have responded to your email. You can reply to that should you need to discuss.
Hi Anand, I am a silent reader of your blog and othe financial blogs as well and slowly but surely learning a lot about personal finance and planning through the posts. Thanks a lot for that.it has been 2-3 months reading all the blogs and now time has come to take some action.<<>> Am I overdivesfying? are there better alternates avaiable than any of my selected funds?
Please need your expert advise.
Thanks,
Nidal
Hi – Just to protect your privacy I have edited your comments that had details on your investments. You can write to me at administrator@justgrowmymoney.com in future.
I will be responding to your query via a separate email from my side.
– justgrowmymoney
Hi
Please send me the FP template. m4u8@hotmail.com
Mahesh – The FP template is available at https://justgrowmymoney.wordpress.com/downloads/. I have also emailed you.
mails are bouncing back
Please write to me at anand.balakrishnan@yahoo.com for the time being
Can i leave you with my Dad’s portfolio as well? I dropped you the same on investta.com but couldnt find a detailed reply. Do let me know if there is any fees for the same and if its reasonable I can afford.
Hi Anand,
I have shared my portfolio with you in your mail . Would appreciate if you could advise.
I very much like your article particularly detailed analysis on asset allocation. To be honest i have been investing in equity past 7-8 years without thinking about debt at all. i would like to take your advice on my portfolio – if you can send the template mentioned in this blog, it would be great.