Six golden rules of asset allocation to build a resilient investment portfolio

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 that 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 emotions and human biases from 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 that 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

The bulk of the effort in choosing the right investment is centered on the ‘best returns’ generating instrument, and very little effort is 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 = percent in Equity/Risk assets. Well, this is very first-level thinking. It is based on the assumption that younger investors have a longer time to make money and hence must allocate a 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 the 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.

6. Taxation

Taxes are happy outcomes. In the obsession to avoid taxes, one may end up taking undue risks. Secondly, investments done purely for the 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.