ASSET

ALLOCATION
THE KEY TO HELP IN YOUR FINANCIAL SUCCESS
Introduction
If you have an opportunity to make your own team in IPL, what will you do? Take all the best
batsman or make a team of all types of bowlers or make a good mix of batman’s, bowlers and
fielders.
To win a match it is important to have good mix of players with different skill sets. Similarly, in
your portfolio you need all kind of asset classes, which will perform in different market
conditions.
A good team mix can be a mantra for winning a match and asset allocation can be a mantra for
a winning portfolio.

What is asset allocation?

Asset allocation is the mix of different asset
classes e.g. equity, debt, gold etc. in an investment
portfolio. The aim of asset allocation is to balance
risk and returns in accordance with different
financial goals and risk appetites. Unfortunately,
asset allocation is not given its due importance by
many investors in India and we see investment
portfolios heavily skewed towards particular asset
classes without factoring in risk and return
consideration.

Asset Allocation
Why is asset allocation important?

Risk and returns are directly related but risk is a double edged sword. If you take too little risk, you
may not be able to make the money needed for your financial goals. On the other hand, if you
take too much risk, you will expose your financial goals to uncertainties of capital markets. Right
asset allocation means that you take the optimal amount of risk to meet your short term, medium
term or long term financial goals.

1 Irrational behaviour is very common in investing because greed and fear plays a big role in
how we invest. When the market is high, people put more and more money in stocks
expecting market to go even higher. When the market is low, people sell stocks fearing
market to go even lower. Such irrational actions harm the long term financial interests of the
investors. An asset allocation based approach takes emotions out of investing and keeps you
disciplined.

Greed & Fear EUPHORIA

Thrill
Anxiety
Excitement
Denial Point of Maximum
Fear & Potential
Fear Optimism

Optimism
Point of Maximum Desperation Relief
Greed & Risk
Hope
Panic
Depression

DESPONDENCY

2 Drivers of investment results

We have seen that investors spend too much time on trying select best performing schemes.
But historical portfolio returns analysis provides overwhelming evidence that asset allocation
is the most important attribute of portfolio performance.

Drivers of investment results

Security Section, 4.6%

Market Timing, 1.8%

Asset Allocation,
91.5% Other Factors, 2.1%

Source: Determinants of Portfolio Performance, published in the Financial Analysts Journal - 2005.

Asset Allocation
3 Winners keep changing
Different asset classes outperform / underperform each other in different stages of
investment cycles. Asset allocation may ensure a degree of portfolio stability in different
market conditions and may give good returns across investment cycles.

The below chart shows how various asset classes performed on year-on-year
basis from 2004 to 2019

Best 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

35% 62% 42% 87% 28% 107% 30% 10% 39% 7% 56% 9% 15% 57% 6% 18%

25% 36% 40% 77% 9% 99% 19% 7% 37% 4% 55% 7% 13% 47% 6% 12%

11% 35% 29% 55% 6% 76% 18% 2% 28% -1% 31% 7% 8% 29% 3% 11%

6% 18% 23% 31% -52% 24% 18% -25% 11% -5% 14% 6% 7% 14% -2% 10%

0% 5% 5% 7% -59% 4% 5% -31% 9% -8% 14% -4% 3% 5% -15% -4%

Worst -5% 4% 4% 6% -71% -9% 3% -34% 7% -28% -1% -10% 2% 0% -29% -10%

Large Cap Equity Mid Cap Equity Small Cap Equity Long term G-sec Corporate Bond Gold

Source: Bloomberg as on 31st Dec 2019

4 Importance of Portfolio rebalancing

Different asset classes outperform / underperform
each other in different market conditions; without
rebalancing, your asset allocation can deviate
significantly from your target allocation.

How does Portfolio Rebalancing happen?

Let us understand the importance of asset rebalancing with the help of an example. Let us assume
you invested Rs 1 lakh in the proportion of 70% equity and 30% debt in 1998. In the first example,
you only did a one-time asset allocation at the time of your investment. In the second example,
you were rebalancing your portfolio every year to bring back the asset allocation to 70% equity
and 30% debt. If equity allocation exceeded 70% equity any year, you sold equity and bought debt
to keep asset allocation at your target. Similarly when equity allocation was below 70%, you sold
debt and bought equity to keep asset allocation at 30%.

Asset Allocation
 Growth of Rs. 1 Lakh
1,400,000
Without Rebalancing Investment Value Rebalancing Investment Value
1,250,000
1,200,000

1,000,000
9,74,000

800,000

600,000

400,000

200,000

0
8

9
0

3
4

2
3

4
5

0
/9

/9
/0

/0

/0

/0
/0

/0

/0

/0

/0

/0

/1

/1

/1
/1

/1
/1

/1

/1

/1

/1

/2
01

01
03

01

01

01
01

03

02

01

01

01

01

03

02
01

01
01

04

02

01

01

01
Source: Advisorkhoj, 31st December 2019

In these two examples, we will use Nifty 50 as the proxy for equity and Nifty 10 year G-Sec Index as
the proxy for debt. Let us see how your investment would have grown over the last 20 years
without any rebalancing. Your investment’s market value at the end of 2019 would have been
around Rs 9.7 lakhs. However if you would have done annual rebalancing the value would
have grown to 12.5 lakhs, an incremental gain of 2.7 lakhs.

Bonds
15%
Bonds Stocks Go Up
30%

Stocks
70% Stocks
85%

Rebalance Rebalance
(Buy Stocks) (Buy Bonds)

Stocks Go Down Bonds

30%
Bonds Stocks
45% 55%
Stocks
70%

Asset Allocation
Types of Asset Allocation / Hybrid Funds
Aggressive Hybrid Funds Equity Savings Fund
These funds have a static asset allocation Equity savings fund essentially aims to
strategy with the flexibility to keep its asset generate returns by investing in equity, debt
allocation within prescribed ranges and arbitrage opportunities. This last
mandated by SEBI. SEBI requires these funds component sets them apart from other
to invest 65 – 80% of their assets in equity or hybrid funds. Essentially, the fund manager
equity related securities and rest in money looks to exploit the pricing inefficiencies in
market or debt securities. Aggressive hybrid the cash and derivatives segments of the
funds follow a rigorous rebalancing process equity market. Thus, the fund's overall equity
to keep their asset allocations within the exposure is partially hedged, reducing its
prescribed limits. It follows a process to buy volatility as compared to an aggressive hybrid
low and sell high and rebalance its asset fund, where the equity exposure is fully
allocation. As per our tax laws, mutual fund unhedged.
schemes which invest 65% or more of their
assets in equity and equity related securities
enjoy equity taxation.

Dynamic Asset Allocation Funds

These hybrid funds also known as balanced advantage funds, dynamically manage their equity
and debt allocations. SEBI has no asset allocation limits for these funds; theoretically, they can
invest 0 – 100% in equity or debt. Different fund managers use different valuation metrics for
dynamic asset allocation, the most common being P/E and P/B ratios. The taxation for these funds
can be impacted if the allocation to equity and equity related instruments is less than 65%.

Asset allocation
Fund category Taxation
Equity Debt

Aggressive Hybrid Fund 65% - 80% 20% - 35% Equity

Conservative Hybrid Fund 10% - 25% 75% - 90% Debt

Dynamic Asset Allocation / Investment in equity/ debt that is managed Can be Equity or Debt,
Balanced Advantage Fund dynamically between 0-100% based on allocation

Min 10% in all three asset class Can be Equity or Debt,

Multi Asset Allocation
(Equity, Debt and Gold) mentioned in Funds SID based on allocation

Min 65%, including Arbitrage

Equity Fund Taxation
Equity Savings* (unhedged Equity usually between Mini - 10%
(due to Arbitrage allocation)
20-45%, remaining arbitrage)

* Hedging % to be defined in fund SID

Asset Allocation
Summary Points
Let us take an example to show market value (at the end of 2019) of Rs 1 lakh investment made in
1998 for different asset allocations with annual asset allocation rebalancing to the target asset
mix. You can see that the maximum wealth creation has taken place in 70% equity and 30% debt
asset mix.

11.23 11.35 11.17

10.71
10.02
9.15
8.16

80% 70% 60% 50% 40% 30% 20%

% Equity Allocation (balance in debt)

Source: Advisorkhoj, 31st December 2019 (Nifty 50 as the proxy for equity and
Nifty 10 year G-Sec Index as the proxy for debt.)

This analysis has several important lessons for investors:-

The asset mixes in the above analysis gave double digit returns over the 20 year period. This
shows that you can beat inflation with asset allocation.

While risk and return are related, you need not take excessive risk to get the best results in
terms of wealth creation.

With asset allocation it is possible to balance risk and return to get superior absolute
returns.

The most optimal asset mix has been around 70% (equity). Hence from a long term
perspective investors can look at Aggressive Hybrid Funds as suitable investment options.

Asset Allocation
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