With Sensex Booming, What Should You Do? Asset Allocation Basics For Dummies

With stock market indices on a tear, and the possibility of investors losing real money if there is a big correction in the near future, the most important mantra to learn is “asset allocation”. Quite simply, asset allocation means putting your money in assets in proportions that are appropriate to your personal capacity to handle risk. Asset allocation saves your core wealth from rapid depletion in case the market moves adversely.

To give a simple example, if you have Rs 10 lakh to invest, and you don’t mind losing half of it due to adverse price movements, it would be logical to put half your money in “safe” assets (bank fixed deposits, triple A corporate bonds, and government post office schemes), and the other half in, say, equity or equity-oriented mutual funds. This is not to recommend a 50:50 split between equity and debt as the norm, but just an illustration about asset allocation.

However, a caveat is in order. We tend to assess risk only in terms of our aversion to losses. Human beings are more averse to making real losses, and less concerned about the loss of opportunity by not taking risks that may give you an equivalent gain or more. If the choice is between losing Rs 10 on a deal or gaining Rs 10 on one, most people would forgo the latter.

So, when we talk about risk aversion, we also need to talk about the risk of not taking adequate risk. In the stock market context, if we define equity as risk, not investing in equity should not be an option for those who can afford to lose some money in the markets over the short- to medium-term.

In fact, the poor understand the risk of not taking risks better than the rich. The rich want to conserve wealth, while the poor want to acquire it even at great risk to their short-term well-being. This is why the poor buy more lottery tickets than the rich; they are willing to forgo short-term losses in the hope that they will hit the big time one day. I am not recommending the purchase of lottery tickets as a form of investment, but just underlining the reasons why some are willing to take more risks even when their economic conditions do not warrant it.

This brings us to the core question of asset allocation. It is not a static concept. Here are a few simple pointers to guide you on asset allocation:

One, your choice of asset allocation should vary depending on which part of your earnings and expenditure cycle you are now in. If you are young, and stay with your parents, you have few expenses of your own and most of your income can indeed go into risk assets. If you are married and have both income and expenses, you cannot put all your money in the equity basket, for you have to save some wealth for future needs. Thus, your asset allocation changes with your income, expenditure and age and responsibility profile over time. So, it is a good idea to reassess your asset allocation policy every two to three years at least.

Two, asset allocation is also dependent on how your assets actually fare in terms of returns and growth. Let’s start with a simple 50:50 allocation to equity and debt. You have Rs 10 lakh to invest, and you put Rs 5 lakh in equity (or, say, an index fund) and Rs 5 lakh in bank fixed deposits. Between last March and now (18 months), the Sensex has more than doubled, and thus your Rs 5 lakh equity investment has become Rs 10 lakh now. On the other hand, your bank fixed deposit would not have grown very much. After 18 months, your net wealth (before taxes) on bank FDs would be barely Rs 5.5 lakh.

This is where your asset allocation needs a rejig. You invested Rs 10 lakh 18 months ago in a 50:50 ratio, but now your assets are worth Rs 15.5 lakh (Rs 10 lakh in current equity valuations and Rs 5.5 lakh in FDs). But with more than Rs 10 lakh in equity, your original asset allocation is no longer 50:50 in equity and debt. It is 65:35 approximately. Now, if you are okay with this new asset allocation, that is if you are okay with 65 per cent of your assets being at risk, that’s fine. But if you are not, you have to sell equity and move some of the gains into fixed deposits or bonds.

The rule to follow is this: if one side of your asset basket is delivering in spades, to maintain the allocation as before, you have to reduce the gaining asset and invest in the other asset to rebalance your portfolio. However, a better way to rebalance assets is to concentrate new investment in the assets which has grown slower. That is, additional investments should be made in debt till you get back to the desired 50:50 ratio.

This is counter-intuitive to what most investment advisers would normally suggest: that you invest more in your winners and cut your losers. Under asset allocation, you invest more in the asset that has made less gains (or even lost value), and less in the one that has made more. Another caveat: don’t presume that debt does not lose value. While FDs don’t lose nominal value, traded bonds tend to gain or lose value depending on the trend in interest rates. If rates are falling, your debt fund will gain; it will fall if rates are rising. This is because traded debt tends to adjust market prices to new yields.

Three, it is important to take taxation into account while allocating or reallocating assets as per your asset allocation plans. For example, if you have invested Rs 5 lakh in equity, and the investment has doubled in value in less than a year, you pay 15 per cent (plus cess) short-term capital gains tax if you sell. For an investment that is longer than a year, the long-term capital gains tax is 10 per cent plus cess. This implies that if you have made a 15 per cent gain in your equity portfolio in six months, there is no need to rejig assets since what you gain from the asset allocation you lose out in taxes.

On the other hand, debt, whether it is fixed deposit or bonds, not only is taxed more, but also needs a longer investment period to qualify for long-term capital gains treatment. While fixed deposit interest upto Rs 10,000 is free from tax under section 80 TTA (it’s Rs 50,000 for senior citizens), in the case of bonds the long-term capital gains tax rate is 20 per cent with indexation after a holding period of three years. And don’t forget the cess on income tax. This implies that equity is better on a tax-adjusted basis for those willing to take the risk of short- to medium-term losses due to market movements.

Four, asset allocations are not only about equity and debt. There is real estate and gold too, though esoteric investment avenues like paintings or rare coins are not for everybody. When it comes to real estate, since they are not easy to buy or sell and transaction costs are high (stamp duties, registration charges, brokerage, etc), one should not consider them as part of the core asset allocation portfolio – unless you are a pro in real estate and know when to buy or sell a property. Illiquid assets should be considered more for their use value (ie, buying a house in order to live in it rather than for investment gains) and not for their investment appreciation value, though that is also possible.

Gold, on the other hand, should be a part of asset allocation portfolios beyond equity and debt. Reason: gold has seldom lost value over centuries. In India, the government offers sovereign gold bonds with 2.5 per cent annual interest and capital gains exemption over a tenure of eight years. This means, over eight years, the interest alone will cover 20 per cent of your cost price. And the capital gains are tax-free.

This primer on asset allocation is not meant to be a specific guide to how much anyone should allocate to which class of asset, but to explain some key aspects of it. For real advice on asset allocations specific to your needs and financial condition, do consult a personal financial or investment adviser.