Well known studies by Brinson et.al. (1986, 1991) concluded that "More than 90 percent of the variation in a portfolio's performance over time is due to its asset allocation". The studies further assert "… investment policy dominates investment strategy (market timing and security selection)." These findings have become the bedrock of financial planning discourses and have their fans and critics alike.
Here are golden rules of asset allocation
1. Rules over Views :
Views are beliefs formed over time and involve predictions about markets. They are based on assumptions about future outcomes. These views differ depending on one’s ‘conditioning’ and may or may not hold true. However, an asset allocation plan based on ‘rules’ or some pre-determined scientific formula which uses actual parameters, is likely to triumph over views and market outlooks.
2. Understanding Behavioural biases : Investing is more behaviour than math
Investment decisions are driven by biases and not necessarily facts. Empirical theories assumed that investors were rational beings and made economically sound decisions based on data. However psychologists who studied investment behaviour, realised that investors make decisions based on biases and emotions. These decisions may or may not be prudent for their financial health. Hence a formula driven asset allocation eliminates the emotions and human biases out of the investing framework.
3. Low Correlation among Asset classes is important
Correlation means how two variables move together. If both variables rise or go down together, they are said to be positively correlated. If one variable does something and the other does the exact opposite, they are inversely correlated. And if there is no relation between the movements of two, they are low or not correlated.
When constructing a portfolio is very important to look at the correlation of the asset classes. Investing in positively correlated asset classes, is not advisable as both asset classes are likely to deliver similar returns and will carry similar risks.
Investing in asset classes which have low correlation or have negative correlation to each other spreads the risk. Over a long term period, such a portfolio will deliver better risk-adjusted returns.
4. Discipline – To Rebalance and alter weights systematically.
Bulk of the effort in choosing the right investment is centered on the ‘best returns’ generating instrument and very little effort directed towards risk, time horizon and goals. Since it is difficult to predict which asset class will perform and when – Asset Allocation is the best way to take care of this uncertainty. Asset Allocation must never be at the mercy of ‘last one year returns’. With regular rebalancing across asset classes one can maximize the benefits of asset allocation.
5. Risk Tolerance and not just Age :
Asset allocation based on age uses a thumb rule: 100 years - Current Age = % in Equity/Risk Assets. Well, this is very first-level thinking. It is based on the assumption that younger investors have longer time to make money and hence must allocate higher portion of their investable surplus to high risk assets. Asset allocation should be based on overall risk tolerance rather than age alone. Risk tolerance is the ability of an investor to tolerate uncertainty of returns. Risk tolerance is a combination of various factors such as one’s income, liabilities, number of dependents, financial goals, need for cash flows, savings, and age.
Taxes are happy outcomes. In the obsession to avoid taxes – one may end up taking undue risks. Secondly investments done purely for avoidance of taxes may lead to sub-optimal outcomes. Optimising taxes rather than avoiding them should be the goal.
Investors would do well not to trivialise asset allocation to a percentage of equity/fixed income allocation. An informed discussion with your financial advisor can be a good first step. These Golden rules can serve as a guideline towards building resilient investment portfolios with the ultimate aim of helping investors achieve their financial goals.
(The author is Head of Products at Motilal Oswal Asset Management Company.)
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