Ringside VIEW IT’S ALL ABOUT DISCIPLINE

Rebalance your asset allocation to cut risks & optimise returns Asset allocation is a three dimensional exercise. Apart from risk and return, knowledge of correlation of assets is also important ASSET allocation is like morality: it is most talked about and less practised. Both have similar problems. On the face of it both are quite simple but the moment you try to implement, they become confusing. For example telling lies is immoral but many scriptures says that one should lie to protect someone or charity in general is good but charity to non-deserving recipient is a sin. The list goes on. Other problem is temptation of instant gain motivates people to deviate from moral behaviour. In spite of such difficulties, we know that people who practice morality gain in a holistic way in the long term and also if the level of morality increases in society, the society as a whole becomes a more efficient and happier place to live.      Similarly, asset allocation even though academically is a very simple concept, people in general have found it very difficult to implement. Like morality, asset allocation also is contextual and hence confusing. Many people also get tempted to deviate from it in search of instant gains and many times end up getting undesired results. If people start getting disciplined about their asset allocation and rebalancing, they are less likely to meet with financial disasters.      At the broader level if most of the investors start practising it, the boom and bust cycles of the asset prices can be smoothened out to an extent (because bubbles will not form as most of them will be rebalancing if markets go up) and overall risk of investment can reduce which will result in happier investment environment.  GET PRIORITIES RIGHT  Various academic research papers have shown that asset allocation return explains around 90-95% of portfolio returns. Stock picking or fund manager selection does not contribute more than 10% of ones portfolio returns. The irony is that most of the investors spend 90% of the time on activities which contribute only 10% of returns. Thus asset allocation is extremely important and one should give enough attention to it. Take the example of equity assets: one may be better of by picking an index funds/ETFs rather then going through analysis paralysis. This will allow him/her to focus on how much equity should be there in the portfolio.  THIRD DIMENSION  Many people are not aware that asset allocation is a three dimensional exercise. Most of us know of two dimensions — risk and return. In simple terms, if one is willing to take higher risk, then expected returns may be higher and vice versa. The third dimension of asset allocation is correlation of assets with each other. In other words it is also an extent of diversification. Blending of non-correlated assets improves risk adjusted returns.      In the context of Indian portfolios currently gold is an important diversifier due to its lower correlation with Indian equity markets.      It is also very important to note that such correlation of assets is not a static thing. It keeps on evolving and hence asset allocation requires periodic monitoring. For example in the early 90s, equity markets of various countries were not correlated and hence most of the global portfolios were constructed based on regional or country indices. But in late 90s due to freer capital movement correlation of all equity markets increased and hence the impact of geographical diversification on the portfolio reduced to a great extent.  REBALANCING  Rebalancing is a very important part of asset allocation. The asset allocation may get skewed due to movement of prices of various assets. It needs to be corrected and brought back to the model allocation for two reasons. The first is that a skewed portfolio may not help you achieve desired results in terms of risk and return. The second reason is that such rebalancing results in partial selling of assets whose prices have moved relatively higher compared to other assets and buying of assets whose prices have moved relatively lower. This becomes an automatic discipline and saves investors from bouts of fear and greed.      Deciding the frequency of rebalancing is also a challenge. Whether, one should do monthly, quarterly or yearly. Too frequent rebalancing increase transaction cost and tax impact while too late rebalancing looses its purpose.      One of the best solutions is to decide an outer limit of tolerance and whenever it reaches that one can do rebalancing. For example, if the model portfolio is say 50% in equity and 50% in debt one can set up limit of say 60-40. i.e if equities rise and its allocation becomes 60% of the portfolio one can sell a portion and bring it back to 50% or vice versa if markets have gone down and equity allocation comes down to 40%. This will ensure that transaction costs are kept in check and transaction happens only when meaningful move in assets occur.      Asset allocation exercise is must for all savers. It inculcates discipline and "discipline is the bridge between goals and accomplishment." RAJAN MEHTA  Executive Director  Benchmark AMC