The question that keeps most investors awake at night is, how does one decide which asset to invest in and how much? This can be answered by identifying a proper asset allocation strategy. Static asset allocation is a time-tested strategy that can provide a realistic blueprint for your investment planning.
Static asset allocation and portfolio rebalancing
Static asset allocation involves identifying a target allocation percentage for each of the asset classes and adhering to this target allocation over your investment horizon (period). The main asset classes are: equity, debt (fixed income), real estate, and commodities. The identification of asset classes and their target allocation in your portfolio is done based on a host of criteria, including your financial goals, current financial position, investment horizon, your risk profile, market conditions and outlook, etc.
Once this target allocation is arrived at, the idea is to stick to this target allocation over the investment horizon irrespective of market movements. Market movements have the potential to alter your asset allocation percentages as your asset values are impacted, resulting in deviations from their target allocation. This is where portfolio rebalancing comes in, periodically restoring the deviated percentages of various asset classes in your portfolio to their target allocation.
Let us suppose you have decided to invest only in equity and debt, and have arrived at a target allocation of 60:40. You plan to invest a total of Rs 10 lakh, hence your portfolio will consist of Rs 6 lakh in equity and Rs 4 lakh in debt.
Now, say, due to market movements during the course of the year your equity investment has appreciated to Rs 8 lakh, while your debt investment has depreciated to Rs 3 lakh, totaling a portfolio value of Rs 11 lakh. Your asset allocation is now 73% equity and 27% debt, or a 73:27 allocation.
This is a deviation from your target allocation of 60:40. To restore your portfolio to your target allocation, you rebalance your portfolio by moving the excess from equity to debt, moving Rs 1.4 lakh from equity to debt. In fact, this forces you to “buy low” in debt markets and “sell high” in equity markets, which is the essence of wealth creation.
When is it suitable
The static asset allocation strategy does not factor in your investment horizon or how near you are to achieving your financial goals. It presumes that your risk-taking ability remains constant throughout your investment horizon. Consequently, this method may not work for those whose risk-taking ability changes drastically over the investment horizon.
This strategy works best for young investors or individuals who have just entered the salaried workforce, since they have a long innings in front of them. It also works for those who have wealth creation as their objective, as opposed to, say, regular income.
Static allocation may also be a good approach for meeting financial goals that either are unplanned in nature or are not non-negotiable in terms of time. Such goals include creating a contingency fund, building emergency corpus, taking a vacation, etc.
While static asset allocation comes handy in certain situations, it has its own pitfalls. Understand both its pluses and minuses before adopting it
This article was originally pubslished in The Financial Express
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