The Sensex may be back at above the 36,000 level, but all it takes for experts to change their views is a few days of sharp declines. Whenever equity markets are topsy-turvy, experts tell investors to focus on ‘asset allocation’. The average Indian investor is just beginning to understand terms like mutual funds, fixed income etc. So, a term like ‘asset allocation’ may seem easy when you hear it. But truthfully it is difficult to practice because it requires discipline, conviction and courage. If you have wondered what asset allocation is and how to do it, read on.

What is asset allocation?

Essentially, asset allocation is based on the premise that different asset classes perform differently in the given market conditions. For instance, stocks provide faster growth and income, but at higher risk. Bonds provide stability and lower risk, but returns do not always beat inflation. Gold as an asset historically does well when other asset classes are performing badly or when there is turbulence. There is also cash as an asset. Do remember that the importance of diversification also stems from the inability to predict the performance of any asset class for a given time period. For instance, it is very hard to predict what will happen to stocks, fixed income or gold in the next one year. Asset allocation is not just a defensive strategy. When done in the right manner, asset allocation can prove to be a big boon to your wealth. This is because losing less means winning more.  

Asset allocation teaches investors to distribute money across a range of assets. Think of it as a mix. Depending on which asset classes you want to put your money, you can maintain a ratio. For example, if you want to invest in stocks and fixed-income assets, you can choose a ratio, say, 50:50, 60:40, 70:30 or even 90:10. One of the biggest tasks is deciding what would be your mix. Do remember there is no rule of thumb to decide this ratio. Investors have to take that call themselves or leave it to their expert/advisor to do the same. Your age, investment risk profile and time horizon are the main ingredients. For example, a young person usually has long-term goals, like building a retirement corpus, and hence he/she can afford to take more risks for achieving that goal. However, if you have a short-term goal, like saving for marriage in 2021, that needs to be met within a quick time, and taking risk is not a good idea. Your risk taking capacity will largely decide what kind of allocation you will have when it comes to the assets. 

Does it work?

Your money portfolio is as good as your asset allocation. Studies have shown how you divide the money between different assets is often a major driver of returns. If you allocated 100 per cent of your money to stocks in 2008 when the equity market crashed by 50 per cent, Rs 1 lakh invested would become Rs 50,000. If you had split Rs 1 lakh 50 per cent in stocks and 50 per cent in debt/fixed-income, your overall losses would be 21 per cent because of allocation to fixed income. In 2011 too, stocks fell by 25 per cent. If you invested 33.3 per cent each in stocks, debt, and gold at the end of 2010, you would not have made any loss despite a sharp drop in equities.

Asset allocation is about deciding how much money will be allocated to which asset. If you are right, you will win handsomely. In case you are wrong, you will not be hurt too much because you did not place all eggs in one basket to start with. To enjoy the 28 per cent jump in the equity market in 2012, you should have had enough exposure by 2011 end, especially after stocks declined by quite a bit. This is why it takes courage. Once you have decided your mix, it is time to wait for results to show.

Important things to remember

Let us assume you have Rs 10 lakh at your disposal. It may be the money you realised by selling your home or your share of parents' assets. If you decide to invest the entire money, there are a few things you might want to consider.

Firstly, most of us are quite exposed to debt or fixed income. Hence, it is important to calculate the right proportion in debt. You may think allocating 25 per cent to debt means giving Rs 2.5 lakh, but it can be a lower amount. This is because most of us have investments in the provident fund, bank deposits etc. These are all debt avenues. Hence, 25 per cent allocation to debt at your portfolio level may have been already reached, because of the investments already mentioned. What’s more, debt asset allocation could be higher than 25 per cent if your strategy was conservative all along. Then, you would have to increase exposure to other assets.

Second, real estate is also an asset exposure. If you have a second house that was bought for investment, it is real estate exposure. Of course, living in a rented house or having just one house, does not count as pure real estate asset investment because you would need to stay there for a long time. Because you have bought a big second flat, your exposure to real estate may be huge compared to other assets.

Third, asset allocation mix can change every few years but should not be done very frequently. If you change the asset allocation every year or six months, a big amount of time will be spent in reorganising the portfolio. Some assets like real estate or gold are big-ticket investments, so hiking them or lowering them is not easy. 

Fourth, your allocation to one or many asset-classes should not be because they have done well or bad last year. This is akin to performance chasing. Nobody wins because they bought last year’s best performers or bet on the worst performers. You win because you made the correct decision to remain invested in an asset or assets. Just because you bought the best assets, there is no guarantee you will gain this year. In fact, you may lose a lot before you gain. Hence, take the decisions based on sound principles and a clear methodology.