DEMOCRATIZING WEALTH CREATION

Module : 1 Chapter : 3

All About
Asset Allocation
 DEMOCRATIZING WEALTH CREATION

All About Asset Allocation

Asset allocation
Let every man divide his money into three parts, and invest a third in land, a third in
business, and a third let him keep in reserve.  —Talmud (c. 1200 BC–500 AD)

Experienced investors understand and know some insightful truths about an investment that a novice may miss. They manage
their investing by following these truths. The first truth is that the most important decision is your long-term mix of assets:
How much you invest in stocks, commodities, bonds or cash. The second truth is that this mix should be determined by the
real purpose and timeframe of the use of money. The last one is to diversify within the asset class and be patient as good things
come in spurts.

According to the paper published by Brinson, Singer & Beebower, ‘Determinants of Portfolio Performance II’ in Financial
Analysts Journal, “over 90 per cent of investment returns are determined by how investors allocate their assets versus security
selection, market-timing and other factors”.

Asset allocation and its significance:

Asset allocation is the process of dividing investments among different kinds of asset classes (equity, debt, commodity and
cash) to minimize risk and also to maximize return at the given level of risk. The reason asset allocation works is because
every asset class exhibits its own characteristic of risk and return that is different from others. Similar assets respond in a
similar fashion to economic and market events. For example, the returns on the equity shares of a company would depend on
the growth in profits and the scalability of the business. This translates into the possibility of a higher long-term return if the
company is managed well and the performance is good.

On the other hand, returns from fixed income securities such as the bonds of a company would depend on the ability of the
company to generate enough cash to pay interest even if the company is not growing. This translates into a steady periodic re-
turn, with limited possibility of capital appreciation. This difference in characteristics of different assets makes asset allocation
work in a perfect way.

What also helps asset allocation is that you cannot predict the short-term returns of any asset class. We saw in the calendar
year (2020) how the returns from equity first saw a dramatic fall in the first quarter and then an equally dramatic recovery
thereafter. During the same period, some of the long duration bond funds generated double-digit returns. Such volatility in
returns may lead to a wrong decision by investors when it comes to entry and exit from their investment, which can ultimately
undermine the overall portfolio returns. Diversification of your investment may help you to avoid such pitfalls.

The following table shows the yearly returns of different categories of assets. You can see winners across asset classes rotating
in the short term, thereby making the timing of asset allocation a difficult task. Therefore, you need to have the right mix of
these assets for consistent returns.

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*Debt has been represented by CRISIL Composite Bond Fund Index; cash represented
by CRISIL Liquid Fund Index while equity has been represented by Nifty 50 TRI Index.

In the years 2005, 2006 and 2007, we saw the equity market giving returns of more than
40 per cent every year. However, the fall in the equity market in the year 2008 wiped
out half of the portfolio value. So, if you had invested Rs 100 at the start of 2005, at the
end of 2008, it would have become Rs 144.5, giving you annualised return of 9.5 per
cent.

In contrast, if you had spread your money among different assets, it would have
narrowed the range of outcomes. So, if you had invested 50 per cent in equity and 50
per cent in debt (10-year sovereign bond fund) and rebalanced it at the end of every
year, the same Rs 100 would have grown to Rs 168, giving you double-digit annualised
returns. This entire process of diversification and investing in different asset classes
have been perfectly summed up by Jack Bogle, American investor and Founder of Vanguard Group, who is also credited with
creating the first index fund. He said, “The most fundamental decision of investing is the allocation of your assets: How much
should you own in stocks? How much should you own in bonds? How much should you own in cash reserve?”

Not long ago, diversification simply meant ‘avoid putting all your eggs in one basket’. The argument was that in such a scenar-
io, the range of possible outcomes becomes very wide. If you invest in a single asset, you might win very big; but you also face
the possibility of losing very big. So, if you had only invested in equity, you would have witnessed the value of your portfolio
declining by more than 40 per cent in 2020 in a span of just two months. Such a large drawdown may have led to panic and
you would have sold your investment at the wrong time.

In the following paragraphs, we will help you design an asset allocation plan based on your goals, timeframe, risk tolerance
and personal financial situation.

How to decide on the right asset allocation?

Now, after understanding what is asset allocation and how it works, the next step in asset allocation is to find which asset
classes to invest in and what percentage should you invest in these asset classes. There are different ways to arrive at the right
asset allocation. Nevertheless, asset allocation linked to the investor’s financial goals is the most appropriate form of asset
allocation strategy. Determining the right asset allocation can be determined by answering these questions.
 What are your financial goals?
 What is your timeframe?
 What is your risk tolerance level?
 What is your personal financial situation?

Financial goals : There are various financial goals for which you save and invest. You might be saving for the down
payment of your home or for your child’s marriage or his or her higher education or comfortable retirement. It is important
to have specific goals so that you know what you are saving for and how much money is necessary and at what time in the
future. Identifying financial goals helps you to put in place a spending and saving plan so that the current and future demands
on income are met efficiently. All your financial goals are important and the type of financial goals such as needs (child’s edu-
cation) and wants (going on international vacation) will determine the types of assets you invest in.

Timeframe : Once you have ascertained your financial goals, the next step is to determine the timeframe when you need
the required money to fulfill your financial goals. This will again help you to select the right asset class. Equity funds of any
category are usually inappropriate for short timeframes (less than five years). Suppose, for example, that you are investing
for your child’s college education, which is due in three years. Now, attracted by the 2017 bull run in the equity market, you
invested in some small-cap funds.
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Unfortunately, even after three years of investment, the value of your investment would have been worth only about 60-70 per
cent of its original value, depending on the fund you invested in. It is this unpredictability and volatility of stocks that make
them unsuitable for short timeframes. The table below shows the rolling returns of Sensex since its inception for different
periods. It clearly shows how the frequency of stock market declines and gains becomes less as investing periods increase and
the volatility represented by standard deviation also declines.

Annualised Return of Sensex Since 1979

Particulars One Year Two Year Three Year Five Year Seven Year Ten Year
Average Returns 21.97 18.78 17.45 15.97 14.63 12.94
Max Return 348.17 148.99 95.81 58.48 52.52 43.67
Min Return -58.15 -24.97 -18.63 -7.35 -6.54 -2.88
Median Return 14.13 14.11 11.95 11.86 12.16 11.97
Standard Deviation 37.75 22.94 18.31 14.21 11.85 10.52
Over the 42-year period from 1979 to 2021 (July), we can clearly see that an investor who picked the worst one-year period
to invest in Sensex (proxy to large-cap funds) would have lost 58.15 per cent. However, the same investment over any 10-year
period would have lost a maximum of 2.88 per cent. Now, we can understand why stocks are poor investments for the short-
term, but can be excellent investments for long-term goals.

To understand the return from the debt funds and cash and cash equivalents, we took CCIL Broad and CCIL Liquid indices,
respectively, serving as performance benchmarks for these assets. CCIL Broad index consists of the top 20 traded bonds,
while CCIL Liquid index constitutes the top five traded bonds. The total returns index (TRI) provides the change due to both
price movements and accrued interest.

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Annualised Return (per cent) of CCIL Bond Index Since 2004

One-year Three-year Five-year Seven-year Ten-year
Broad Liquid Broad Liquid Broad Liquid Broad Liquid Broad Liquid
Particulars
TRI TRI TRI TRI TRI TRI TRI TRI TRI TRI
Average 8.10 7.60 8.20 7.60 8.40 7.80 8.30 7.70 8.30 7.60
Min -6.80 -12.80 1.00 -0.30 3.40 1.50 5.10 4.40 5.60 4.90
Max 27.80 33.30 14.20 14.50 11.70 11.20 10.90 10.60 9.40 8.70
Median 7.70 7.30 8.40 7.70 8.40 7.80 8.60 7.80 8.50 7.90
Standard Deviation 5.54 6.21 2.36 2.36 1.34 1.40 1.19 1.12 0.89 0.89
The above table [annualised return (per cent) of CCIL Bond Index since 2004] shows the annualised return of the indices
for different periods. It clearly shows how the bonds are much more stable. They generate lesser return than equity; however,
they also exhibit lower volatility and are more stable. Hence, debt funds should be given more weightage for your short-term
financial goals.

Risk tolerance
The next step in deciding your asset allocation is to know your level of risk tolerance. In order to help determine whether your
portfolio is suitable for your risk tolerance, you need to be honest with yourself as you try to answer the question, “Will I sell
if the market sees a plunge similar to the first quarter of CY20?” Risk tolerance is not what you do on an average day in the
stock market; it is what you do when the worst is happening. This is because only during the bad period you take the drastic
step of locking the paper loss into an actual loss.

The equity market or any other market (including commodity) corrects by 20 per cent or 40-50 per cent on a regular basis.
This fall may be triggered by regular business cycles or by larger credit cycles and irrational exuberance, which create bubbles
and busts. You need to understand that you are allocating your investment to different assets for the bad times, and not for the
good times. Also, appropriate asset allocation will help you to follow the maxim—when you win, quit playing! Or at least, dial
down the risk.

The ‘sleep test’ is one of the ways to help determine if your asset allocation is in accordance with your risk appetite. When
setting up an asset allocation plan, investors should ask themselves: “Can I sleep soundly without worrying about my invest-
ments with this particular asset allocation?” The answer should be an unequivocal yes since no investment is worth worrying
about and losing your sleep.

So, if you believe that a larger fall in the value of your portfolio does not disturb you, larger allocation can be done to equities;
otherwise, stick to larger exposure to bonds. Below is the table that shows the worst annual return and average return with
different asset allocations. For equity, we have taken returns of BSE Sensex, and for bonds we have taken returns of the 10-
year Sovereign Bond Index, with the period of study being 20 years ending 2020.

Worst annual loss based on stock/bond allocation (2000–2020):

Allocation Worst annual loss (per cent) Average returns (per cent)
100 per cent stocks -52.54 15.42
80 per cent stocks/20 per cent bonds -36.64 14.05
60 per cent stocks/40 per cent bonds -20.74 12.67
40 per cent stocks/60 per cent bonds -8.55 11.3
20 per cent stocks/80 per cent bonds -3.05 9.92
100 per cent bonds -10.18 8.54
Simply change your allocation between stocks and bonds in our portfolio until you reach a comfortable sleep level.
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Personal financial situation

The personal financial situation of an investor has a direct impact on the type of security he decides to invest in and allocates
within his asset allocation plan. This not only includes investments that are visible and for which you write a cheque, but it
also takes into account the financial characteristics of your job and long-term career that are invisible and can be termed as
human capital. It is a way of quantifying the present value of your future wages, income and salary. This human capital can
exhibit the characteristics of both bonds and stocks.

For example, a government employee with a pension and good medical facility has a character of bond as his income is stable
and less volatile. So, such investors can increase their allocation towards equity as the ‘human capital’ will form a part of the
bond weightage. Contrary to this, if an investor is working in a private sector company that is engaged in a very cyclical busi-
ness, human capital in this case is akin to equity. When there is a boom in the cycle, he may earn a handsome salary; however,
in the case of a downturn, he may even lose his job. Therefore, such an investor should lighten the equity risk and hold more
bonds in his financial portfolio. In short, whenever you decide your asset allocation, you should consider both financial as
well as human capital.

Designing your personal asset allocation plan

It is difficult to recommend specific portfolios as one size does not fit all. As discussed above, every individual will have dif-
ferent goals, timeframes, levels of risk tolerance and personal financial situations. Nonetheless, we will try to generalise it and
design an asset allocation plan based on financial goals. Firstly, different financial goals should primarily be identified based
on the timeframe. They can be:

n Near term goals (less than three years)

n Short-term goals (between 3-5 years)
n Medium-term goals (between 5-10 years)
n Long-term goals (between 10-15 years)
n ery long-term goals (more than 15 years)

Once you have categorised your financial goals in terms of different time periods, the next step is to divide them into needs
and wants. There are some need-based goals that you cannot avoid such as your retirement, child’s education, medical care,
and others, while there are other financial goals such as going on an international vacation or upgrading your mobile phone
every year, which are your wants that are avoidable and can be postponed. The following table is a rough guide to your asset
allocation based on your financial goals and their criticality.
Needs Wants
Goal Time Horizon Equity (per cent) Debt (per cent) Equity (per cent) Debt (per cent)
Near term goals (less than three years away) 0 100 0 100
Short-term goals (between 3-5 years away) 0 100 20-30 70-80
Medium-term goals (between 5-10 years away) 40-50 50-60 50-60 40-50
Long-term goals (between 10-15 years away) 60-70 30-40 80-90 10/20/21
Very long-term goals (more than 15 years away) 70-80 20-30 90-100 0-10

You should also understand that as and when your goals move towards attainment, asset allocation must also change accord-
ingly. For example, when you are 30-year old and saving for your retirement, you can invest up to 80 per cent in equity. As
you become older and reach the age of 55, your asset allocation should now match with short-term goals and 100 per cent of
your assets should go towards debt. Besides, within the broader asset class of equity and debt, there are sub-asset classes. For
example, within equity, you can have large-cap, mid-cap and small-cap funds. For a conservative investor, equity allocation
should be made in large-cap funds.

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Moderate or aggressive investors can invest in mid-cap and small-cap funds only if the goal is beyond 10 years. In the case of
debt funds, try to match the duration of the bond fund with your financial goal. For example, if your goal is three years away,
you can choose a debt fund that has Macaulay duration of three years. What we have discussed above is only one of the many
approaches that one can follow to arrive at an appropriate asset allocation.

Asset allocation may be also linked to the stage of an investor’s life. The lifecycle of any individual can be typically sub-divided
into a young investor, a young couple in the mid-30s, a mature couple with grown-up children and a retired couple. Never-
theless, what remains common in all approaches is that short-term goals should have more allocation towards debt, while
long-term goals require more allocation to equities.

The following glide path can be used as a rough guide to asset allocation, depending on your age and years left for retirement.
For example, if your current age is 25 and if you are likely to retire at the age of 60, then the total number of years left for
retirement is 35. Hence, according to the following graph, you need to invest 90 per cent in equity and 10 per cent in fixed
income securities.

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Registered Office Address: 419-A, 4th Floor, Arun Chambers, Tardeo, Next to AC Market, Mumbai - 400034

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