Jama Wealth Blog

We often hear experts talk about asset allocation and the rebalancing of portfolios. We will now find out why this is almost like a free lunch in investing! And it is time to do so as we are beginning a new financial year and the markets are taking a sharp turn.

If you are switching from regular or indirect mutual funds to Direct Plans, it is a good time to spring-clean your portfolio and set it upright. Don’t just switch to the same fund’s direct plan. Take a hard look at the portfolio.

Here are :

6 Tips For A Free Lunch in Investing :

1. Asset Allocation Helps Reduce Risk
2. Rebalancing Guards Your Portfolio Against Shocks
3. Periodic Rebalancing Guides You to Your Goals
4. Rebalancing Enforces Discipline
5. Make Sure You Rebalance Yearly Once
6. Take Professional Help

1. Asset Allocation Helps Reduce Risk

Asset allocation is nothing but the application of a lesson learned way back in school, ”Do not put all your eggs in one basket”. In other words, it means that we should not invest our entire money in only one asset or asset class. Our investment should be spread across the 4 different financial assets, namely Equity, Long Term Debt, Short term Debt, and Gold.

This helps us in balancing our risks and rewards and achieve our investment goals, as each of these assets serves a particular investment objective. Equity helps in growth, Long Term Debt provides stability, Short Term Debt takes care of Liquidity and Gold works as portfolio insurance.

Asset allocation is similar to having a balanced diet. One needs to eat different types of food and in some pre-determined proportion. Asset allocation is about investing our money across the different asset classes in some specific proportion. For example, Mr. A might allocate his funds across the 4 asset classes as under Equity 45%, Long term Debt 30%, Short Term Debt 15%, and Gold 10%.

2. Rebalancing Guards Your Portfolio Against Shocks

Shock absorbers anyone on this rollercoaster ride of investing?  Re-balancing, in simple terms, is about sticking to one’s asset allocation. Once Mr. A has invested let us say, Rs.100,000 across the 4 asset classes in the proportion mentioned above, his money will start growing at different rates. Let us assume that, during a period of 1 year, Equity gave a return of 20%, Long Term Debt 8%, Short term Debt 6%, and Gold gave a negative return of 2%. His portfolio will now look as under:

S.No	Asset Class	Amount invested	Asset Allocation	Return	Amount after 1 year	Asset Allocation
1	Equity	45000	45%	20%	54000	48%
2	LT Debt	30000	30%	8%	32400	29%
3	ST Debt	15000	15%	6%	15900	14%
4	Gold	10000	10%	-2%	9800	9%
		100000			112100

When Mr. A reviews the portfolio, he is happy that he invested a larger amount in Equity as Equity gave the highest return of 20% p.a. However, he is unhappy that his overall portfolio gave a return of only 12.1%, whereas if he had invested the entire amount in Equity, he would have earned 20% or Rs.20,000.

At this point in time, the tendency is to get out of other Asset classes such as LT Debt, ST Debt, and Gold, and invest the entire amount in equity. However, investors who have learned the lesson of diversification may not do that and allow the portfolio to remain as is.

Even if Mr. A leaves the portfolio as is, kindly note that the asset allocation has changed. Equity is now 48% of the portfolio. The proportion of LT Debt and ST Debt has fallen to 29% and 14% respectively, whereas Gold constitutes only 9% of total assets.

Let us extend this scenario to another 4 years, although it may not be possible to achieve the same returns year after year. After 5 years, Mr.A’s portfolio will be as under:

S.No	Asset Class	Amount after 5 years	Asset Allocation
1	Equity	1,11,974	60%
2	LT Debt	44,080	24%
3	ST Debt	20,073	11%
4	Gold	9,039	5%
		1,85,167

Nothing wrong with that, except that Equity is now 60% of the total portfolio, as opposed to the original asset allocation of 45%. Is that a problem? Let us assume that year 6 experiences global turmoil and there is a 40% fall in equities, Debt continues to earn the same rates but Gold has shot up by 20%. Mr. A’s portfolio at the end of the 6^th year would be as under:

S.No	Asset Class	Amount after 5 years	6th year returns	Amount after 6 years
1	Equity	1,11,974	40%	67,185	46%
2	LT Debt	44,080	8%	47,606	32%
3	ST Debt	20,073	6%	21,278	14%
4	Gold	9,039	20%	10,847	7%
		1,85,167		1,46,916

Nothing wrong with that apparently. However, if one were to look at returns earned over the period and more importantly if one of the financial goals were to be met during the 6^th year, there could be a huge setback due to a sudden fall in equities in the 6^th year. This is because we did not rebalance the portfolio every year.

3. Periodic Rebalancing Guides You to Your Goals

In our example, the asset allocation at the beginning and end of the first year changed, as the returns varied across different asset classes. Out of the total portfolio value of Rs.1,12,100, equity is Rs.54,000, whereas as per the asset allocation plan of Mr.A, it should be only 45%. Having adequate liquidity ready for your goals is very important here.

In other words, in a portfolio of Rs.112,100, equity at 45% should be Rs.50,445 (45% of Rs.112,100). Thus, equity is more to the extent of Rs.3,555. As part of rebalancing, Mr.A needs to sell equity to the extent of Rs.3,555. Similarly, Gold, which should have been 10% of the portfolio, or Rs.11,210 in value is only Rs.9,800. The investor needs to buy Gold to the extent of Rs.1,410.

This table explains the Rebalancing to be done:

S.No	Asset Class	Amount invested	Asset Allocation	Return	Amount after 1 year	As per asset allocation	Action to be taken
1	Equity	45,000	45%	20%	54,000	50,445	Sell Equity	-3,555
2	LT Debt	30,000	30%	8%	32,400	33,630	Buy LT Debt	1,230
3	ST Debt	15,000	15%	6%	15,900	16,815	Buy ST Debt	915
4	Gold	10,000	10%	-2%	9,800	11,210	Buy Gold	1,410
		1,00,000			1,12,100			0

4. Rebalancing Enforces Discipline

Contrary to the general investor behavior of investing more in asset classes that yield higher returns, rebalancing forces the investor to sell or redeem assets that have given higher returns and buy assets that have given a lower return. This is an example of rupee cost averaging. Thus, over a period of time, one accumulates more at lower levels and actually books profits at higher levels, resulting in higher overall long-term returns.

Of course, rebalancing as a strategy may appear too conservative if an asset class is on a continuous upward trajectory, giving supernormal returns year after year. However, even in this case, the original asset allocation is always maintained, and the investor does not lose much. It is just that she could have made more by having a higher allocation to such an asset.

Unfortunately, we do not know in advance how the asset class is going to perform. We do know that most of the time, returns from any asset class are not consistently above or below “average market returns.” In this situation, rebalancing not only protects our gains but also enhances overall portfolio returns.

5. Make Sure You Rebalance Yearly Once

It is recommended that this exercise is carried out annually or when the investor feels that there is a significant change in circumstances. Investors must guard against knee-jerk reactions and certain macro events and rush to make changes in their allocation.

It is recommended that an investor not only rebalances the portfolio as per his/ her asset allocation but also takes the opportunity to review his/her portfolio in the light of the change in circumstances from the time the allocation was earlier done to the time of review.

6. Take Professional Help

Taking a professional Investment Advisor’s help is highly recommended to arrive at the asset allocation that is specific to an investor, based on his/ her goals. A trusted advisor who works without conflict of interest will always work to protect and grow your wealth. A commission-based advisor may have other interests.

It is very difficult to make the emotional decision of selling an apparently high-performing fund or buying in a falling market. SEBI Registered Investment Advisors at Jama.co.in can be trusted to give you the right advice, hand-hold you in the process of arriving at your specific asset allocation based on your goals and risk profile, as well as for periodic review and rebalancing.

Check this Vanguard report on how an advisor can add significant alpha to your portfolio by helping with asset allocation and rebalancing. The unbiased advice that only a SEBI RIA and a Direct Mutual Fund Platform can give you is an unbeatable combination.

Conclusion :

Balancing our risks and rewards and achieving our investing goals, as each of these assets serves a particular investment objective. Equity helps in growth, Long Term Debt provides stability, Short Term Debt takes care of Liquidity and Gold works as portfolio insurance.

Asset allocation is similar to having a balanced diet. One needs to eat different types of food and in some pre-determined proportion. Asset allocation is about investing our money across the different asset classes in some specific proportion.

Happy Investing!

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