Tame the volatility of equity markets with asset allocation

Equity markets are volatile. They have always been volatile. They will remain volatile. In fact, all asset classes exhibit price volatility as long as there are trades happening in open markets involving  so many market participants.

One of the ways to tame this volatility is to know how you invest. Click on the link below to read further ...

Tame the volatility of equity markets with asset allocation

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The English translation is as under:

Last time we wrote about the power of SIP to tame the risk of price volatility. However, this is suitable for individuals having regular income and savings. Someone may wonder, what about those who do not have regular savings? What about the retired investors?

Retired investors invest their money and then draw regularly out of these investments. Many are comfortable with fixed income investments and get the regular income in form of interest. On the other hand, there are some who invest in mutual funds and withdraw their money regularly. At the same time, in case of some, they may have money that may remain invested without any withdrawal from the same.

In fact, it is not just retired investors; many investors from other categories have some money that need to be untouched. No income may also be required out of the same as some other investments may be generating enough.

If such money is going to remain invested for long periods of time, one need to find how much should be invested in the volatile asset class called equity and how much in safe fixed income investments. This process is popularly known as asset allocation. (Asset allocation may involve investment in many other asset categories apart from equity and fixed income, e.g. real estate, international stocks, currency, etc.)

The big question in deciding the asset allocation is: “How much money should be allocated to which asset category?” The answer depends on three things: (1) the need to take investment risks, (2) the ability to take such risks, and (3) the willingness to take risks. One can have a separate detailed discussion on these three. However, broadly, the need to take risks arises when one needs returns higher than the safe short-term Government securities. The ability depends on one’s financial as well family situation and the willingness is a function of how soundly one can sleep at night after making certain investments.

Once the allocation is made to various asset classes, one has choices (1) let the allocations change in line with changes in asset class performances, or (2) rebalance the asset allocation to the original ratios, or (3) take market views and increase or decrease the allocations to various asset categories based on one’s views on the relative attractiveness. Most investors would be better off with taking the approach number 2.

Let us understand this approach, known as rebalancing the asset allocation to the original levels.

Let us assume that after assessing the needs of one of the clients, the advisor recommends investment of 50% of the assets in an equity mutual fund and 50% in a money market mutual fund. The investor and the advisor then decide to review the performance of the portfolio every six months. The review process is also very simple. The objective would be to maintain the allocation between equity fund and money market fund at 50:50.

Given that the stock prices are volatile over shorter terms and move in line with the profits of the company over longer periods, we are likely to see the value of the equity mutual fund go up and down over time. When that happens, the asset allocation would stray from the 50:50 that was set originally.

When the equity prices move up faster than the debt prices, the allocation will get skewed in favour of equity and our review process would restore it back to 50:50 by shifting some money from equity fund to debt fund. In the other case, when the equity prices move adversely, the balance would get skewed towards debt and the balance can be restored by shifting from debt fund to equity funds. What you are doing here is selling equity when the prices run up and buying when the units got cheaper. One is able to do this without having to worry about analyzing what is happening in the market place.

The above example is applicable to an investor, who has a static portfolio without any additions into the portfolio or withdrawals from the same. In reality, the investor may get inflows, which need to be invested in the portfolio or have a need to take some money out of the investments. In such cases, at the time of investment or redemption, the investor has to look at the current market value of the equity fund and debt fund and rebalance the portfolio to 50:50.

Automatically, the money goes into equity fund when the stock prices are low and into debt fund when the stock prices are high.

The only problem with the above is that what looks so simple is very difficult to execute since the approach means ignoring all the sound bytes taking place around you. It takes a lot of courage to chart one’s own course and more importantly, to continue walking that path – at times, all alone.

Maintaining the asset allocation helps an investor work the volatility in one’s own favour.

Wish you all a very Happy New Year!

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.