Asset Rebalancing will reduce your portfolio risk and improve returns
We have discussed the importance of asset allocation a number of times in our blog. Asset allocation ensures that you invest in the right asset class to meet your financial goals. It ensures that, you take the right amount of risk; too much or too little risk, can both harm your financial goals. One aspect of asset allocation often ignored by many retail investors in India is the importance of asset re-balancing. What is asset re-balancing? Some time back, I read an interesting analogy between asset allocation and gardening in a finance blog. Think of your investment portfolio as your garden. It takes meticulous planning and hard work to plant a garden. But what will happen, if you do not tend to your garden Rs Different plants and shrubs grow at different rates depending on the season. The different plants in your garden will start competing with each other for space, water and nutrients. Therefore, if you do not tend to your garden (weed, prune, water) on a regular basis, your garden will soon bear an untidy look. Also the faster growing plants may harm the growth of slower growing plants. Similarly, in your investment portfolio, depending on the asset cycles, some asset classes will grow faster than other asset classes. Remember, different asset classes have different risk / return profiles. Therefore, over a period of time the risk profile of your investment portfolio can be very different from the risk profile that, you had envisaged. Let us understand this, with the help of a simple example. Let us suppose, you invested Rs 10 lakhs in equity and debt assets. You desired asset allocation is 60% equity and 40% debt. Let us assume, the equity assets grow at 17% compounded annual growth rate (CAGR) over the next 4 years, while the debt assets grow at 7% CAGR. After 4 years your total investment value will Rs 17.7 lakhs. What will your asset allocation be after 4 yearsRs It will be 70% equity and 30% debt; in other words, your investment portfolio has become more risky than you had intended it to be in the first place. As an investor, you may be quite happy with the returns (Rs 7.7 lakhs profit on an investment of Rs 10 lakhs) but not concerned about the change in your asset allocation. However, you must remember that, bear markets are inevitable in asset cycles. Let us suppose in year 5, equity falls by 30%, while debt continues to give 7% returns. Your portfolio value after year 5 will be Rs 14.3 lakhs (Rs 3.3 lakhs year on year loss). With a 60% equity and 40% debt asset allocation, you would have expected a loss of 15% if equity fell by 30%, but in reality your loss was nearly 20%. It is surely going to hurt you, especially, if you needed the money at the end of year 5, but you should ask yourself, why did you make a bigger lossRs Because over the last 4 years, your asset allocation and the risk profile of your investment changed considerably. This is why asset rebalancing is important. Asset rebalancing is reviewing your investment portfolio on a regular basis and making suitable changes to your portfolio, to bring it back to your desired asset allocation. Asset rebalancing reduces the volatility of your portfolio returns (volatility is always stressful) and also gives you a higher return on your investment. In this post, we will discuss the importance of asset rebalancing and show how it not only reduces your portfolio risk, but also improves your overall portfolio returns. Asset Rebalancing Techniques There can be a variety of asset re-balancing techniques. The most basic asset re-balancing technique is reviewing your investment portfolio from time to time and switching from one asset class to another, to bring it back to your target asset allocation technique. Investors who have the requisite expertise can use more sophisticated techniques to switch between equity and debt depending on relative valuations and yields, e.g. investors can switch from equity to debt when equity valuations seem expensive and vice versa. Investors should also rebalance their asset allocation as they approach their specific investment goals, e.g. switch from more risky to less risky asset. Asset Rebalancing Reduces Risk We will discuss with an example, how asset re-balancing reduces your overall portfolio risk. Let us recap the basic concept first. Depending on where we are in the asset cycles, some asset classes grow faster than other asset classes. This causes an imbalance in portfolio asset allocation relative to your desired allocation. Going back to our gardening example, in different seasons, different plants in your garden grow faster than some other plants. If you want to maintain the desired look of your garden, you have to prune to faster growing plants and provide more water, nutrients etc to the slower growing plants. Similarly, in your portfolio from time to time you should prune or trim faster growing assets, e.g. equity and add to slower growing assets, e.g. debt, to bring your portfolio back to the desired asset allocation. Please, remember we said trim and not cut, because cutting would defeat the purpose of asset allocation. Gardeners among our readers would know that, trimming has to be done with a lot of care. You should trim only the amount (or units of mutual funds) that is required to bring it back to the desired asset allocation. You should then add the trimmed surplus to the asset that is growing slowly. Let us now discuss the example. For our analysis, we have looked at a 15 year period from the beginning of 2001 to 2016 (September 22). This period included several market cycles (bull markets and bear markets). We had a great bull run in India from 2004 to 2007. We also had the worst global financial crisis in the last 80 years in 2008. Post 2008, we had both bull and bear markets. Since, we are covering wide variety of
Importance of Financial Planning
We believe that every financial decision in our life should be based on some goal. The goal can be building a retirement nest egg, saving for your children’s college education or wedding, saving for a down-payment for property purchase, protecting your family from financial distress due to unforeseen risks, protecting your family from health risks, protecting your home or business from fire or other hazards etc, but unless you have an objective, you will not be able to make the right decision. Financial planning, whether formal or informal, is a process where you define your goals in quantitative terms and then, formulate a plan which will help you meet all the different financial goals in your life. Financial Planning Financial planning is no different from a structured problem solving framework. Every structured business problem solving exercise has 5 specific steps (the same can be applied in financial planning as well):- Clearly defining the problem (in the context of financial planning, identifying your goal) Defining success criteria (in the context of financial planning, quantifying the goal, determining the goal horizon, understanding the risk tolerance level and other important parameters that define success) Analyzing the current situation (in the context of financial planning, understanding your income and expenses, assets and liabilities, risks and opportunities, asset allocation etc) Evaluating multiple alternatives / solutions (in the context of financial planning, evaluating multiple asset classes, product classes, schemes, plans etc) Selecting the best solution (in the context of financial planning, from risk / return, liquidity, tax etc perspectives) and executing it in the most efficient manner Benefits of Financial Planning The first step of financial planning is to define specific goals. The more specific the goals are the better. As an investor, especially if you are young, you may not have enough clarity about all the financial goals in your life. This is where an expert financial planner or adviser can help you. He or she can help you define the goals across your savings and investment lifecycle. He or she can then, help you determine the specific quantitative targets you need to reach the specific goals. Your financial planner can help you to determine, how much you need to save and invest each month / quarter / year to meet your goals.You should know that, any financial plan is based on certain assumptions. These assumptions can and will change over a period of time. How you define a goal success (changes in lifestyle, your personal situation) also changes over a period of time. Therefore, a financial plan is not static, but dynamic in nature. A well thought out financial plan is, however, key to meeting your financial objectives. Without a financial plan, you are at the risk of falling short of your financial goals. Budgeting is the next step of financial planning. This is probably the most important step of financial planning, but also the most ignored one. Even if you have the most detailed and well structured financial plan, if you are not able to save enough, you will not be able to meet your financial goals. Saving habits are very personal, depending on your lifestyle, relative to your income levels. The objective of a good financial plan is to enable you to meet financial goals, without having to sacrifice the lifestyle commensurate with your income. Different individuals and families have different spending habits, relative to their income. People who have monthly budget are more likely to be in control than the people who do not have monthly budget. These people are further down the track in meeting their financial goals.While financial planner or adviser may not actually prepare your budget, he or she can help you give you guidance on how to prepare one. Budgeting is not a hugely time consuming exercise. While preparing your budget, you should try, as much as possible, not to skip minor details, because through a careful budgeting you may be able to identify expenses, which you can easily reduce, without any noticeable impact on your lifestyle.Remember, even a small additional savings can make a big difference to your long term wealth, with the help of power of compounding. Just to give you an example, even an additional Rs 500 monthly savings, invested in equity assets yielding 20% return, will generate a corpus in excess of ? 1 Crore over 30 years. How you invest your savings (debt or equity or real estate), plays a very important role in ensuring the success of your goals. Different asset classes have different risk return characteristics. Too much risk can result in loss of money, while too little risk may prevent you from meeting your long term financial objectives. Asset allocation is the process of balancing your risk and return objectives. It is one of the most important aspects of financial planning. A financial planner or adviser will provide guidance to investors with regards to their asset allocation strategies, in order to meet their short term, medium term and long term financial objectives. Having a financial plan helps you prepare for risks. Risks are unforeseen events that can cause financial distress. The worst case contingency is an untimely death, which can result in financial distress for the family, apart from the emotional trauma. Financial planning can help us prepare for such contingencies through adequate life insurance. Another contingency is serious illness that can have an impact on your savings and consequently your short term or long term financial objectives. A good financial plan will make adequate provisions for health insurance. There can be other contingencieslike temporary loss of income or major unforeseen expenditures. Financial plans will help you prepare for such contingencies. Tax Planning is another important aspect of financial planning. When you have income, you come under the ambit of tax. Tax planning starts when a person starts working and continues almost through-out one’s life, even after retirement. Different investment products are subject to different tax treatments. Financial planning can not only help you save taxes (under Section