04/01/2019
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 market
conditions in our analysis, it is not biased by any particular market
condition(s) and therefore, the conclusions we can draw will be fairly robust.
Let us go back into the past and assume that, we are
in the beginning of 2001 and we have Rs 10 Lakhs to invest. Our desired asset
allocation is 60% equity and 40% debt. For our equity investment (Rs 60% of Rs
10 Lakhs = Rs 6 Lakhs), let us assume that, we invested in CNX Nifty (or an
index fund that tracks the Nifty. We could have also invested in a diversified
equity mutual fund and could have got higher returns than the Nifty, but for
the sake of simplicity in this analysis, let us assume we invested the equity
portion of our portfolio in Nifty. The chart below shows the Nifty price
movement over the last 15 years.
For the debt portion of our investment (Rs 40% of Rs
10 Lakhs = Rs 4 Lakhs), we chose a short term accrual debt fund. We will
explain why we chose a short term accrual debt fund later. Let us assume that,
the returns of short term debt fund are the same as the returns of CRISIL short
term bond fund index. In reality, a short term debt mutual fund would have
beaten the CRISIL short term bond fund index, but in this post, we are discussing
a concept and therefore, we will not get into a discussion on which debt fund
scheme gave the best returns. For the sake of simplicity, we are assuming that
we got returns of the CRISIL short term bond fund index. The chart below shows
the annual returns of CRISIL short term bond fund index from 2002 to 2016.
We used the most basic asset re-balancing technique,
which 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. So we reviewed our asset allocation after each year, and
if the allocation percentage of an asset was higher than the desired allocation
(60% equity and 40% debt), we would reduce that asset class and add to the other
asset class. Let us now explain why we chose short term accrual debt fund for
our debt investment. Since we will rebalance our asset at the end of every
year, we did not want to take interest rate risk in our debt investments. Short
term accrual debt funds have very low interest rate risk. Please note further
that, the base year of CRISIL short term bond fund index is April 2002. Since,
our analysis begins at 2001, we have taken the prevailing bank 1 year fixed
deposit rates as proxy for CRISIL short term bond index.
In 2001 Nifty fell by nearly 16%, whereas debt gave
8.25% return. The equity value of our portfolio was Rs 5.04 Lakhs and debt
value of our portfolio was Rs 4.33 Lakhs (total Rs 9.37 Lakhs). Our asset
allocation ratio at the end of 2001 was, therefore, 54% equity and 44% debt.
Remember our target asset allocation was 60% equity and 40% debt. Therefore, we
switched Rs 58,000 from debt to equity to bring it back to our target asset
allocation (of 60% equity and 40% debt) in the beginning of 2002. After
rebalancing our equity portion was Rs 5.62 Lakhs and debt value of our
portfolio was Rs 3.75 Lakhs. In 2002 Nifty rose by 4.2%, whereas debt gave 7.1%
return. The equity value of the portfolio at the end of 2002 was Rs 5.86 Lakhs
and debt value of our portfolio was Rs 4.01 Lakhs (total Rs 9.87 Lakhs).
Our asset allocation ratio at the end of 2002 was 59%
equity and 41% debt. The equity allocation was still less than the target
allocation; the debt allocation being higher. Therefore, we switched Rs 6,400
from debt to equity to bring it back to our target asset allocation in the
beginning of 2003. After rebalancing our equity portion was Rs 5.93 Lakhs and
debt value of our portfolio was Rs 3.95 Lakhs. In 2003 Nifty rose by 74% (a
bumper year for equity), whereas debt gave 5.7% return. The equity value of the
portfolio at the end of 2003 was Rs 10.3 Lakhs and debt value of our portfolio
was Rs 4.17 Lakhs (total Rs 14.5 Lakhs). We were now in a profit, but our asset
allocation ratio at the end of 2003 was 71% equity and 29% debt. The equity
allocation was more than the target allocation, while the debt allocation was
less.
Since the equity allocation at the end of 2003 is more
than the target allocation (debt allocation is less), therefore, even though we
were tempted by equities, we switched Rs 1.62 Lakhs from equity to debt to
bring it back to our target asset allocation (of 60% equity and 40% debt) in
the beginning of 2004. After rebalancing our equity portion was Rs 8.69 Lakhs
and debt value of our portfolio was Rs 5.79 Lakhs. The table below shows how
asset re-balancing worked in all the years:-
Notes: 1) In Rs
Lakhs 2) Positive signs implies switch from debt to equity and negative sign
implies switch from equity to debt.
In our blog, we have always stressed the importance of
discipline in investing, because we believe discipline is more important than
intelligence in your final investment outcome. Discipline essentially is
controlling your emotions and sticking to your strategy. Two human emotions
influence our investing behaviour, greed and fear. Greed and fear, more often
than not, lead to two outcomes in capital markets, real losses or opportunity
losses. From an emotional standpoint, both greed and fear cause us to regret
later. A disciplined investor is not driven by these emotions and simply sticks
to his or her strategy. We will now see how this strategy paid off. The chart
below shows the annual returns of two strategies; the green bars show the annual
returns when you do not make any change to your portfolio (no asset
re-balancing) and the purple bars shows the annual returns with asset
re-balancing.
You can see that, with rebalancing (purple bars) your
losses in bear markets / corrections are much smaller. The volatility of your
portfolio is significantly lower with asset rebalancing. Lower volatility adds
stability to your portfolio, should you need the money for your personal needs
at a time when markets are in correction mode. While the volatility with asset
rebalancing is lower (hence risk is lower), let us see which strategy would
have given higher absolute returns over the last 15 years. The chart below
shows the growth of Rs 10 Lakhs in a 60% equity and 40% debt portfolio in two
scenarios; one with no asset rebalancing (green line) and another with asset
rebalancing (purple line).
You can see that, asset rebalancing (purple line) gave
us higher returns compared to no rebalancing (green line). Rs 10 Lakhs
investment in 2001 would have grown to Rs 54 Lakhs by September 22, 2016 with
no rebalancing. However with asset rebalancing, the same Rs 10 Lakhs investment
in 2001 would have grown to Rs 61 Lakhs by September 22, 2016. The delta
between the two strategies is Rs 7 Lakhs. The asset rebalancing strategy gave a
CAGR of 12.9% on our investment, while no asset rebalancing would have given a
CAGR of 12% only. Readers should note that, in our analysis, we ignored the
impact of taxes but even we included taxes in our analysis, it would make only
a marginal impact to our final outcome.
Conclusion
The asset rebalancing strategy that yielded almost 1%
extra CAGR was not rocket science. The reason why asset rebalancing lowers risk
and gives higher returns is also very intuitive. Asset rebalancing essentially
means, we are buying low and selling high, the mantra of investing success.
What it involved was a little bit of extra effort in monitoring your asset
allocation, that too only once every year.
You do not have to worry about equity valuations and
fixed income yields. All you have to do is to see the current equity to debt
allocation percentages from time to time and rebalancing your portfolio to
align it with the desired asset allocation. If you are working with a good
financial advisor, you can outsource even that little bit of extra effort to
your advisor. You and your financial advisor can also work together, to enrich
the basic asset rebalancing strategy with valuation based investment decisions
and further enhance your returns. Most professional / institutional investors
incorporate asset or portfolio rebalancing in their investment strategy.
Financial advisors should also integrate asset rebalancing as part of their
portfolio management strategies for their clients, to help them navigate better
through the vagaries of capital markets and meet their client’s financial
goals.
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