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Investment planning: Four cardinal rules of asset allocation

When you construct a portfolio with asset classes that have low correlation with each other, higher returns from one part of your portfolio will balance the losses from another part when markets fall.

There are certain rules of asset allocation that no investor can ignore.
There are certain rules of asset allocation that no investor can ignore.

By Hemanth Gorur

Asset allocation is a way of determining how much to invest in each of the four major asset classes—equity, debt, commodities, and real estate. Each of these asset classes come with its own pluses and pitfalls, and thus investors’ preference of asset classes may drastically differ.

However, there are certain rules of asset allocation that no investor can ignore. Let us see what these rules are.

Rule 1: Invest in at least three asset classes

Suppose you had a sum of Rs 10 lakh to invest. What happens if you invest the entire sum in a single asset class, say, equity? If the stock markets fall, your entire investment depreciates. This can happen irrespective of the asset class as long as you are investing in a single asset class.

To avoid this scenario, you are better off investing in a portfolio of at least three asset classes so that if one or two asset classes experience a downtrend in prices, the other asset classes will act as a buffer and preempt your portfolio from taking a haircut.

Rule 2: Keep correlation between asset classes low

Rule 1 works only if you ensure Rule 2. In the earlier example, if you had distributed the `10 lakh across physical gold, gold ETF, and debt funds only, and if the markets had risen, you would have lost an opportunity for much higher returns. Both gold and debt are defensive asset classes, and are unable to leverage bullish market sentiments like equity can. They are seen to have a high correlation between themselves.

The vice versa is also true. When markets plummet, and if your only investments had been in equity and real estate, your entire portfolio would have taken a hit. This is again because equity and real estate have higher correlation than do equity and gold for example, as both are negatively affected by bearish market sentiments.  However, when you construct a portfolio with asset classes that have low correlation with each other, one part of your portfolio would help realise higher returns when markets rise and the other part of your portfolio would minimise losses when markets fall.

Rule 3: Rebalance portfolio periodically

The only way you can grow your investments consistently over the long term is if you buy low and sell high. Consider a portfolio of `10 lakh invested in equity and debt in a 70:30 ratio. Portfolio rebalancing involves maintaining your portfolio at the target ratio of 70:30 irrespective of market movements. Suppose the equity markets fall by 10% while debt markets rise by 1% in the next one year. Your portfolio ratio has changed to 68:32. Applying portfolio rebalancing, you need to restore the target ratio of 70:30 by selling debt and buying equity. In effect, you have “bought low” in the equity markets and “sold high” in the debt markets.

Conversely, if equity markets rise by 10% and debt markets fall by 2%, your portfolio ratio becomes 72:28. To restore it to 70:30, you need to sell equity and buy debt. Thus, you have “bought low” in the debt markets and “sold high” in the equity markets.

Rule 4: Switch from maximising returns to protecting returns

The danger of maintaining a static asset allocation is that, when your financial goals or retirement years are near, the equity part of your portfolio can suddenly fall in value based on adverse market movements. To prevent this, you can gradually decrease your exposure to equity and correspondingly increase exposure to debt in the last 5-10 years before your financial goals mature or retirement years begin, as debt is considerably safer than equity.

While investment rules are there for a reason, the judicious application of those rules lies in the hands of the investor, where discretion and enterprise are required in equal measure.

The writer is founder, Hermoneytalks.com

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