How investors should go about allocating money in different asset classes to get the maximum benefit of diversification and when and how rebalancing should be done.
As equity markets are on a roll right now, there could be a tendency for first-time retail investors to go overboard on equity exposure. Could you share your perspective on the dangers of having exposure to a single asset class?
Markets have seen a tremendous rally recently. If we look at the broad equity market index (S&P BSE 500), it has delivered a staggering 146% since March 2020 lows till date (Oct 1, 2021). This rally is largely fuelled by foreign flows and rising retail investor participation. For example, the number of equity trading accounts now stands at 70 million which is almost double of what it was at the start of 2020, right before COVID pandemic. Also, foreign portfolio investors in FY2021 have poured $37 billion in Indian equities.
Given the sharp rally in markets, there could be a tendency for the first-time retail investors to go overboard on equity exposure – this can be explained with a behavioral finance bias i.e., overconfidence bias where one tends to demonstrate prediction overconfidence based on recent gains in the stock market, tempting them further to add exposure to equities. There are two major consequences of overconfidence bias, one is to underestimate risk & overestimate returns and second, hold a poorly diversified portfolio.
If we understand the history of assets, there are strong reasons explaining the drawbacks of owning a single asset. For example, let’s look at equities – periods like the tech bubble burst around 2000-2001, global financial crises 2008 and the recent fall due to COVID are periods where markets saw a drawdown or correction of anywhere between 30% to 60%. Such events can expose an investor to significant capital loss and directly impact the investment goal.
Not just equities, but it is true for any other asset as well. Another example could be someone who is planning for retirement but invests only in fixed deposits runs a risk of eroding wealth if the FD rate or yield on the debt portfolio is consistently lower than the inflation.
If one would have invested only in gold say Rs 100 ten years back, it would have only grown to Rs 193 which is 6.8% annualized returns for a ten-year period versus equity which would have grown to Rs 345 i.e., 13.2% annualised return. On an absolute basis, this is a difference of 152%. This highlights the possibility of missing out on growth opportunities over the long term and the portfolio might not be able to generate enough wealth to meet a financial goal.
These are some of the major drawbacks of limiting a portfolio to a single asset.
How many asset classes should investors ideally have in the portfolio, and which are those?
An investor can consider various assets such as, domestic equity, international equity – which are called growth assets as they offer high growth potential, fixed income, and physical assets like real estate and gold.
But it is important to first understand the key benefits of having exposure to these assets. Let’s consider equities, one can participate in the Indian economic growth story and growth in corporate earnings. Similarly, international equities provide us exposure to different growth opportunities in the global markets. It also provides a hedge against rupee depreciation. In the case of debt (fixed income), it offers stable cash flow and helps in reducing risk in a portfolio.
A portfolio that depends too heavily on a single factor to drive returns is effectively a forecast of that factor. For example, returns for a portfolio heavily concentrated in oil stocks will depend very heavily on oil prices. Such factors are often very difficult or impossible to forecast accurately. So, investors should aim to diversify their portfolio among different assets in such a way that returns will be driven by a range of unrelated factors. Besides, investors should stick to an asset which they understand and are comfortable with.
How should investors go about deciding the percentage of allocation in each asset class?
Now, this is the most crucial part of constructing a portfolio. Various research shows that asset allocation decision drives 80-90% of the portfolio’s performance. Thus, making it important to get this step right.
The approach that one can consider is the top-down approach. First, start by identifying the appropriate investment horizon and goal that one is planning for. It is also important to understand willingness towards risk. For instance, have you invested in equities in the past and what was your reaction when markets corrected sharply in March 2020? Did you sell or buy more during such periods? What can be the maximum volatility or capital loss that you can accept? This might indicate your willingness to take risk.
Accordingly, this helps in defining broad asset class split i.e. how much should be allocated to equity/debt. For instance, someone who has a short investment horizon, say 1 to 3 years and a low willingness to take risk can look at equity allocation of around 5%-15%. On the other hand, someone who has a high-risk appetite and a long investment horizon of 7 years and beyond can consider a much higher allocation to equities.
Once you have identified that let’s say, 70% exposure to equities at a broad asset class level is what you are comfortable with, the next step is to look at the sub-asset class exposure i.e. what should be the large, mid, and small-cap split. At a sub-asset class level, one can look at the market index for reference. For example, S&P BSE 500 index has around 80% large-cap, 15% mid-cap and 5% small-cap. One can use this as a start point and allocate and then as per their view across the market cap, tweak the allocation. Accordingly, for a portfolio with 70% exposure to Indian equities, the split can be 56%/10%/4%. This can basically be the target allocation.
Once this is done, a series of back-testing and forward-looking analysis needs to be done to test different combinations of asset mixes and identify an optimal asset allocation. This simply means identifying a mix of different assets that offers the highest return for a given level of risk and vice-a-versa.
As Warren Buffett once famously said, investing is simple, but not easy. One can always seek the help of a financial adviser or an investment firm that can build a multi-asset portfolio since there’s a lot of science and art that goes into defining asset allocation that will provide the right balance to the investor.
How often and what are those trigger points when the asset allocation should be rebalanced?
One of the key elements that any investor must consider when managing a portfolio is when and how frequently to re-balance back to target weights. Rebalancing also serves the purpose of being disciplined with investing. It helps to sell high when markets are overvalued and buy low when they are undervalued.
While this subject is both important and hotly debated, we have found no academic work to support the view that there is an optimum rebalancing period. We believe that rebalancing requires significant thought and should be done in a way that is consistent with the market valuations. Based on one’s view on the markets, rebalancing activity can be purely ad-hoc in nature. For example, if one thinks that the equities are overvalued and if the portfolio is running a higher allocation as compared to the target weight because of a rally in markets, then based on the market view portfolio can be rebalanced back to the target allocation.
For example, someone who starts with 50% equity 50% debt portfolio and after a few months the allocation changes to 55/45 due to rally in equity markets. Should investors rebalance the portfolio back to target? Well, it may seem like a simple rule, but understanding the market valuations is really important to take overweight and underweight calls. That’s where investment experts or financial advisers can step in and help investors to review and monitor their portfolios on an ongoing basis.
Having said that, for simplicity purpose, investors can also look at rebalancing the portfolio back to the target allocation once a year. However, one should also be mindful of unnecessary transaction costs and tax implications because of frequently rebalancing the portfolio. This can have a significant bearing on the portfolio return over the long term.