Saturday School introduces a new series of articles on the all-important aspect of asset allocation - a process that research suggests contributes the highest to long term portfolio performance. We kick off this series with a three part write up from a young advisor who is going places - Sachin Jain (click here to know more). Sachin starts off with an introduction to the concept of asset allocation in this article, which will be followed up by a more nuanced understanding of strategic and tactical asset allocation, and will then conclude with practical insights from his rich experience as a successful wealth manager.

It never is a one way street up

Indian stock markets have been the best performing market across the world this year with the benchmark Nifty delivering more than 17% return year to date. This performance comes at the back of two major corrections, first when the Nifty touched all time high of 9119.20 on 4th March 2015 and corrected to 6825.80 on 29th February 2016, a correction of 25.15% in 362 days and second from 7th September 2016 high of 8968.70 to 7893.60 on 26th December 2016, a correction of 12% in 100 days. These corrections were not only sharp but they lasted for sometime before regaining the levels back. Hence now when the Nifty is at all time high of 9624.55 the key dilemma really is whether "is it a good time to invest or exit?"

The answer to the dilemma: asset allocation

I think the answer lies in the fundamental investment discipline known as "Asset Allocation". As per asset allocation theory one should distribute their investments into different asset class & further diversify within each asset class. For example if one has Rs. 100 to invest and suppose there are 4 different asset classes namely Equity, Debt, Real Estate & Cash then he should judiciously distribute his Rs. 100 in all 4 asset class & not invest all his money in one single asset class. The selection of what proportion of money should one invest in each asset class depends upon his/her risk profiling. Risk profiling mainly takes into account the familiarity with each asset class, liquidity requirement, time horizon & tolerance towards price fluctuations. After a thorough evaluation of risk an asset class mix can be derived it is famously known as "Strategic Asset Allocation". So, if I am an investor who wants to invest for a period of 5 years with low fluctuation and capital preservation as my key goal then an allocation of 20% into Equity, 10% into Cash & 70% into Debt may be my suggested asset allocation or strategic asset allocation which unless I change my risk profile will remain constant through-out my life. Now, I may due to my familiarity and reading on an asset class, expect that particular asset class to do well during a particular period of time and therefore during this time I may increase my allocation to this particular asset class only for that duration selectively or vice versa if I don't like a particular asset class. So in my above example my suggested equity allocation may be 20% but given my conviction on equities I may increase it to say 30% and reduce cash to 0% for a particular period. The new allocation will then look like 30% Equity and 70% Debt. This is called "Tactical asset allocation". The deviation in tactical asset allocation cannot be large or else it would demand a re-assessment of risk itself.

The above discipline will help an investor to avoid such dilemma at all times. In continuation with our above example suppose I would have gone with my suggested asset allocation to begin with and after a year my portfolio would be returning me approx 10% return (see table below) bulk of which has come from equity. As you can see almost 45% of portfolio gains are contributed by equity. Now as per current market value my asset allocation on equity has increased from 20% to 22% while on debt it is down to 68% from 70%. At this stage I should follow the discipline and SELL 2% of my equity to invest it into debt thereby re-aligning my portfolio weights to my strategic asset allocation. Similarly when equity market will correct then my allocation to equity would reduce compared to my allocation to debt which is when I should SELL my debt holdings to re-align my portfolio weight in accordance to my strategic asset allocation.

While doing this I will be selling equities constantly as the equity markets continue to rise up and vice versa when they go down. This will help me en-cash my gains constantly, reduce portfolio risk and resist temptation as the method here is quite scientific.

Hence the clear answer is being true to your asset allocation. So if your suggested equity allocation is 20% and you have never invested in Equity then this is your time to get-in. On the contrary if you are heavily invested into equities and are now over-shooting your strategic as well as tactical asset allocation then now is your time to sell.

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