By Hemanth Gorur
The question that keeps most investors up at night is: how do you decide which asset to invest in and how much? This question can be answered by identifying an appropriate asset allocation strategy. Static asset allocation is a proven strategy that can provide a realistic blueprint for planning your investments.
Static asset allocation and portfolio rebalancing
Static asset allocation consists of identifying a target allocation percentage for each of the asset classes and respecting this target allocation over your investment horizon (period). The main asset classes are: stocks, debt (fixed income), real estate and commodities. The identification of asset classes and their target allocation in your portfolio is done according to a multitude of criteria, including your financial objectives, your current financial situation, your investment horizon, your risk profile, the conditions and market outlook, etc.
Once this target allocation is established, the idea is to stick to this target allocation over the investment horizon regardless of market movements. Market movements have the potential to alter your asset allocation percentages as your asset values are impacted, causing deviations from their target allocation. This is where portfolio rebalancing comes in, periodically restoring the deviated percentages of the various asset classes in your portfolio to their target allocation.
Suppose you have decided to invest only in stocks and debt and you have reached a target allocation of 60:40. You plan to invest a total of Rs 10 lakh, so your portfolio will consist of Rs 6 lakh in stocks and Rs 4 lakh in debts.
Now, let’s say, due to market movements during the year, your equity investment appreciated to Rs 8 lakh, while your debt investment depreciated to Rs 3 lakh, totaling a portfolio value from Rs 11 lakh. Your asset allocation is now 73% equity and 27% debt, an allocation of 73:27.
This is a deviation from your target allocation of 60:40. To restore your portfolio to your target allocation, you rebalance your portfolio by moving the excess from equity to debt, by moving Rs 1.4 lakh from equity to debt. In effect, it forces you to “buy low” in debt markets and “sell high” in equity markets, which is the essence of wealth building.
When is it appropriate
The static asset allocation strategy does not take into account your investment horizon or the degree to which you have achieved your financial objectives. It assumes that your risk-taking capacity remains constant throughout your investment horizon. Therefore, this method may not work for those whose risk-taking capacity changes drastically over the investment horizon.
This strategy works best for young investors or individuals who are just entering the world of salaried work, as they have a long sleeve ahead of them. It also works for those whose goal is wealth creation, as opposed to, say, regular income.
Static allocation can also be a good approach to achieve financial goals that are unplanned in nature or non-negotiable in terms of time. These goals include creating a contingency fund, building an emergency corpus, taking vacations, and more.
While static asset allocation is useful in certain situations, it comes with its own pitfalls. Understand its advantages and disadvantages before adopting it.
The writer is the founder, Hermoneytalks.com
Stick to a plan
The idea is to respect the target allocation over the investment horizon
Portfolio rebalancing brings asset classes back to their target allocation
This strategy works best for young investors