Dhaval Kapadia, Director, Portfolio Strategist, Morningstar Investment Adviser, wrote this post for Moneycontrol.com from where it has been taken.
Various studies have shown that asset allocation or the mix of asset classes such as equity, fixed income, cash and gold, in a portfolio is a key determinant of its performance in terms of risk and return.
A suitable asset allocation for a portfolio would be based on various factors including one’s investment horizon, risk appetite or willingness to take the risk, need for regular income, etc.
Typically, longer the investment horizon and willingness to take risk, higher would be the allocation to an asset class such as equity, which tends to generate higher returns over the longer term (7 to 10 years and above) vis-à-vis other asset classes but can be volatile and even generate negative returns over the short term.
Once an asset allocation is decided, is it essential to review it and how often should one do it? Typically, each asset class generates varying returns over time periods, for instance one asset class can generate a positive return say over a 1- or 2-year period (like equity over the last 2 to 3 years) whereas another asset class can generate a negative return over the same period (like gold over the last 1 to 2 years).
This varying performance across asset classes (which is quite regular) would result in the asset allocation deviating from its original / starting allocation.
For instance, if one started with a portfolio on January 1, 2014 with an allocation to equity (50%), debt (40%), gold (5%) and cash (5%), the allocation as on October 31, 2017 would be 56% (equity), 37% (debt), 3.66% (cash), and 3.36% (gold).
Clearly, the allocations have moved away from the original allocation. This would result in either the expected portfolio risk rising (in case equity is higher than the original allocation) or the expected portfolio return falling (in case the debt is higher).
In other words, the asset allocation could differ from one’s risk and return objectives based on one’s investment horizon and risk appetite and impact the achievement of investment goals.
Therefore, it would be considered essential to review one’s asset allocation and not just the performance of the underlying securities/funds on a regular basis and if required rebalance the portfolio to original weights.
Rebalancing involves reduction of allocation to an asset class, whose percentage weightage in the portfolio has risen above its initial weightage and investing the proceeds into another asset class in the portfolio whose weight is lower than the initial weight.
This can be achieved by partially or fully selling certain holdings in the asset class that has a higher weightage and buying others in the asset class that has a lower weightage.
Asset allocation review and rebalance can be undertaken either at the end of fixed / pre-determined time periods such as every year and/or based on significant deviations from one’s original allocations.
To avoid frequent rebalancing resulting in transaction costs (such as exit loads) and taxation impact, it is advisable to set-up tolerance bands or ranges around each asset class. If the allocation moves out of the range, one could consider rebalancing the portfolio.
The ranges could be determined as +/-5% or 10% around the original weights. For instance, for a 50% equity and 50% debt portfolio, the allocation to each asset class could be allowed to vary in the range of 45% to 55% and a rebalance would be triggered if the allocation moves outside the range.
While making a rebalancing decision, it is important to consider transaction costs and tax impact of such changes. Regular rebalancing also helps to adopt the time-tested investment mantra of ‘Buy Low & Sell High’ to generate consistent performance in one’s portfolio.
While rebalancing one would be reducing allocation to an asset class that has performed strongly in recent times and increasing allocation to an asset class that has underperformed.
