Introduction to Different Types of Asset Allocation
We have all heard of the saying, “Don’t put all your eggs in one basket”. The expression focuses on the importance of diversification which is one of the core principles of investment planning. This article will focus on the different types of asset allocation and how it helps an investor balance risk and returns.
Asset allocation is the best way of diversifying your investments. Over 90% of your investment results come from asset allocation. Asset allocation is an investment strategy that aims at building an investment portfolio by spreading the investment amount across various asset classes in varying proportions.
We at Glide invest suggest that an investor spread his or her investments amount across various asset classes like:
- Domestic equity (preferable equity mutual funds rather than direct equity)
- International equity mutual funds
- Fixed income
- Real estate
- Cash etc.
The logic behind diversifying among different asset classes is that their historical price movements show low or no correlation. Thus, with diversification among asset classes, an investor can reduce risk and generate good returns. The proportion allocated to different asset classes is reviewed from time to time depending on things like a change in risk profile, increasing age with every passing year, investment time horizon, etc.
Types of Asset allocation
Investors can use various asset allocation strategies for their investments. Some of these strategies include:
- Strategic asset allocation
Strategic asset allocation involves investing a certain percentage of money in each of the selected asset classes as part of core asset allocation. This strategy consists of sticking to the base asset allocation throughout the investment period. For example, a 30-year-old investor wants to start investing for her financial goals. So she approaches a financial advisor who recommends the following strategic asset allocation: equity – 70%, debt – 20%, and gold – 10%. In this case, out of every Rs. 100, the investor will have to invest Rs. 70 inequities (preferably equity mutual funds rather than direct equity shares), Rs. 20 in debt products and Rs. 10 in gold. This is also known as static asset allocation.
In the year 2020, the equity markets and gold outperformed, giving high returns and debt products did okay. During the year-end portfolio review, the investor will see that the equity and gold proportion in the portfolio has risen higher than the mandated 70% and 10% due to outperformance. The ratio of fixed income has dipped below 20% as it performed okay. So, to revert to the strategic asset allocation of 70:20:10, the investor will have to sell some of her equity and gold holdings and invest the proceeds in debt products. This process of reverting to the mandated asset allocation is known as asset rebalancing. Strategic type of asset allocation is helpful for investors who want to maintain discipline in investments for goal planning.
- Tactical asset allocation
The strategic asset allocation that we discussed above has the limitation of being static. This does not allow room to take advantage of market opportunities that may arise from time to time for making additional returns. This is where tactical asset allocation comes into the picture. With tactical asset allocation, an investor can deviate from strategic asset allocation for short periods to capitalise on any opportunities that may arise.
For example, in February-March, when the Covid-19 virus was spreading across the world, including India, there was a lot of uncertainty about how it will affect economic activity and human lives and its impact on stock markets. During such times of uncertainty, gold as an asset class tends to do well. During such times, it will make sense to reduce equity exposure and increase gold and debt exposure for an investor following tactical asset allocation.
The Government started lifting the lockdown in phases and re-opening the economy in stages from June 2020. As a result, economic recovery started picking up, and over time, Covid-19 cases began going down. The stock markets also took note of this and started factoring in economic recovery and thus started going up. At this stage, the investor can once again revert to the strategic asset allocation by increasing equity exposure and reducing gold and debt exposure.
An investor following a tactical type of asset allocation tries to time the markets, which requires a lot of expertise. Once the short-term opportunity has played out, the investor should rebalance his/her investment portfolio to revert to the base strategic asset allocation.
- Dynamic asset allocation
The dynamic type of asset allocation strategy involves regularly adjusting/changing the percentage of money allocated to various asset classes based on specific parameters like age, market conditions, risk profile, investment time horizon, etc. For example, some people change their asset allocation every year as their age increases. As a result, with every passing year, the percentage of equity allocation goes down, and the percentage of debt allocation goes up, while the gold allocation may stay constant.
Dynamic asset allocation mutual fund schemes or balanced advantage mutual fund schemes follow the dynamic asset allocation strategy. They invest in equity and debt and manage the investment proportion dynamically based on parameters like price-earnings (P/E) ratio, price to book (P/B) ratio, and others.
Let us understand how they do it with the example of Aditya Birla Sun Life Balanced Advantage Fund. The fund invests in a mix of equity and fixed-income securities. As a result, the equity exposure can range anywhere between 65-100%, as shown in the below table.
The equity exposure is dynamically managed using the price-earnings (P/E) based approach. This means when the market starts getting overvalued, the equity allocation is reduced. This equity allocation is monitored monthly and rebalanced every quarter.
The fund takes a call of the equity allocation based on the P/E ratio of the S&P BSE 100 Index. As shown in the above table, when the P/E range is below 14, the equity allocation range is 80-100%. On the other hand, as the P/E range goes up (the market goes up and gets overvalued according to the fund manager’s view), the equity allocation range goes down and vice-versa.
Which type of asset allocation strategy should individuals use
The type of asset allocation strategy will depend on your risk profile, investment time horizon, and other parameters. For example, if you want to maintain discipline in investments, you should go for strategic asset allocation. On the other hand, if you wish to reduce your equity exposure with every passing year, you should go for dynamic asset allocation. While following strategic asset allocation, you can use tactical asset allocation if you want to benefit from specific market opportunities. You should do this under the guidance of an expert, or you can download the Glide Invest App and let it give you a personalised asset allocation mix for each goal. You can download the Glide Invest App from Google Play Store or Apple App Store and get started.