Sensex at 12K: Revisit your asset allocation

With markets at a high, it's time you revisited your asset mix. Asset allocation is like a balanced diet. The importance of a 'balanced diet' is well known. A right mix of carbohydrates, proteins, fats, vitamins etc. is essential for maintaining a healthy body.

However, there is no single magic formula. Not only the so-called 'right' balance varies from person to person, but with time it varies for the same person also.

This 'need for a balance' is also applicable to our financial well-being. Our financial health will be fit and fine provided we maintain the right balance between the various asset classes.

Different asset classes have a (i) different risk profile, (ii) different liquidity profile and (iii) different returns profile. Similarly, at any given time, a person has a financial profile, which is a combination of security-liquidity-returns.

We have to create such a mix of asset classes out of our investment portfolio, whose security-liquidity-returns profile match with our overall financial profile. This will result in the 'right' balance and make us financially fit and happy.

For example, take the case of a retired person, who (a) is no longer earning a regular income from his job, (b) has educated and married off his children and (c) has, over the years, built-up a decent retirement corpus. Such a person would require his investments to give regular returns; cannot take risk where he can lose money as he has no way of earning it back; and may require money for medical emergencies.

Such a person falls on one end of the financial spectrum -- a very conservative risk-averse investor. His need would be satisfied through substantial investments in debt instruments, e.g. bank FDs, debt-based mutual funds, bonds, etc. Such instruments pay regular interest and are relatively risk-free and fairly liquid.

Thus his asset allocation may somewhat look-like as under:

And on the other end of the financial spectrum, we have a fresh MBA graduate who (a) is getting a good salary, (b) presently carries no liabilities and (c) is interested in growth of his investment portfolio. He is the very aggressive risk-taker investor.

Such an investor does not need any liquidity as he is getting a regular pay and does not mind a high-risk high-return investment strategy. His asset allocation will somewhat look like:

And in-between these two ends will lie the rest -- moderately conservative investors, medium-risk investors, aggressive investors. And accordingly their asset allocation will vary from 'a high-debt low-equity portfolio' to 'a low-debt high-equity portfolio'.

One could do a further allocation within an asset class. For example, in equity one could allocate suitably between index scrips, large cap, mid cap, small cap, sector specific, etc.

There is another issue related to asset allocation, which we usually tend to neglect. And that is 're-balancing.'

A person's financial profile changes with time. And with this change in his financial profile, his debt-equity proportion would also vary so as to maintain the balance. This calls for a regular review and modified asset-allocation, as and when necessary.

A re-balancing will also become necessary due to different growth rates of various asset classes.

Say you have Rs 100 to invest and your debt-equity allocation is 30:70. After one year the Rs 30 in debt has grown to say Rs 32.40 @8% p.a. and the Rs 70 in equity to Rs 94.50 @35% p.a.

The debt-equity allocation has now become 25.5:74.5. Thus the portfolio has become riskier than your profile of 30:70. Therefore, you need to sell Rs 5.67 of equity and put in debt to bring back the debt-equity ratio to 30:70.

Conversely, say after one year the debt had grown to Rs 32.40 @8% p.a., but equity portion suffered a loss of 20% and reduced to Rs 56. The debt-equity ratio changed to 36.7:63.3. Now you need to sell Rs 5.88 from debt and put into equity.

Re-balancing could also be done through fresh investments, which could help one save on the capital gain taxes.

Most people do not rebalance their portfolio regularly. The reasons are many. One reason is inertia or laziness. Other could be tax-liability, which may accrue during this re-balancing.

Or the consequent transaction costs. Or maybe one would want to continue betting on the 'winning' horse, little realizing the same horse may not be the winning one next year too. Or, it may be psychologically difficult to invest in equity when someone has suffered a loss.

Apart from maintaining the risk-profile, this re-balancing has another important benefit. It brings discipline to equity investing. It makes you sell and book profits when the market has gone up. And forces you to invest in equity when the markets are down.

Thus it makes one follow the age-old philosophy of equity investing -- buy low and sell high. Psychologically, we tend to do the opposite -- sell when the markets are falling and buy when the markets are rising.

Another advantage of allocating one's resources across various asset classes is diversification, which in turn reduces risk and increases the potential to make more money. Since different assets experience different market fluctuations, proper asset allocation insulates the entire portfolio from the volatility of one single asset class.

A well-balanced, well-diversified and periodically re-balanced investment portfolio is a key to a financially healthy future.

The author is an investment advisor. He can be reached at smatai@hotmail.com.

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