Sign up for the exclusive ‘asset allocation’ club

There’s nothing anonymous about this AA (Asset Allocation) club. It’s an addiction you wouldn’t want to get rid of

By Priya Sunder

Nassim Taleb’s book The Black Swan is a fascinating read. He writes about uncertainty and our limitations as human beings in taming this uncertainty. We base our world view on what we see, observe and read. We generalise and make predictions based on these observations and interpretations. And yet, one aberration shatters the foundations of our knowledge and we go back to the drawing board all over again.

Taleb was a finance professor, writer and former Wall Street trader. He outlines a black swan event as an outlier, which “lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility”. He argued that though black swan events are low frequency, they are high impact and almost impossible to predict. Because of their tremendous consequences, people must factor such events to occur in the future, and plan for them. The financial crisis of 2008 and the dot-com bubble of 2000 are examples. So how should we protect ourselves from their impact?

The answer: asset allocation, the most critical decision-making weapon you have in your arsenal to fight such catastrophic events. Sadly, most of us do not use it until it is too late. Not only does asset allocation cushion you against black swan events, it also protects you against normal volatilities of the market.

Asset allocation is about having the right proportion of various assets in your portfolio, which react differently to different market events. When some investments fall, others go up, so your overall returns average out. It helps diversify assets across different investment classes, which have a low correlation with each other, so when one or more of them is badly affected, the others stay constant or rise to keep the overall portfolio afloat.

Apportioning your wealth among different asset classes and rebalancing is a powerful way to ensure you stay the course without getting swayed by emotions. It offers you a much better decision-making framework than ad hoc investing or investing only in specific asset classes.

The right allocation matches your return expectations to your risk profile. It matches your goals to your portfolio and balances growth with stability. Hence, every rupee invested is tagged to a purpose.

Short-term goals such as paying for fixed annual commitments are best met by short- to medium-term debt investments that strive to match inflation, and which are accessible at short notice. Long-term goals such as creating a retirement corpus are best met through assets like equity. Equity beats inflation comfortably but is risky over the short term.

Each portfolio needs to strike the right balance between equity and debt. Asset allocation ensures that neither risky nor conservative investments dominate, and that you systematically trim down the overall risk or safety whenever required.

Rebalancing accomplishes key behavioural changes—sticking to your goal and being disciplined in your investment behaviour. Your goal is your target portfolio ratio. This could range based on your age, risk appetite and goals.  Also, you are forced into the discipline of reviewing your portfolio each quarter, selling what you have too much of and buying what you have too little of.

Through a combination of target setting and portfolio discipline, investors are less susceptible to market noises and thus make rational decisions. Asset allocation highlights the difference between what seemingly rational people should do and what they actually do in times of market extremes. Even though rebalancing involves apportioning assets between cash, bonds and stocks, it is admittedly difficult to enforce because of our psychological biases. Investors tend to hold on to an equity-heavy portfolio when the markets are high, and desist from investing in stocks when the markets are low. Such behaviour clearly explains why investors experienced negative returns long after the crash of 2008. Those investors who sold equity when the markets soared and continued to invest through the lows from 2008 were rewarded with high double-digit returns.

Making money in the long run is not so much about picking the right instruments. In fact, if you are not qualified to do so, you must refrain from such activities. It’s also not about determining your own asset allocation. In reality, more important matters will take precedence, and you will ultimately fall prey to what 90% of us are victims of—emotions, biases and lethargy. If you want membership into the 10% guild, sign up for the niche AA (Asset Allocation) club. There’s nothing anonymous about this club and it’s one addiction you wouldn’t want to get rid of!