Asset allocation

Everything that feels like investing — choosing the fund, choosing the stock — sits downstream of one question: how much in equity, how much in debt, how much in cash and gold?

An asset class is a collection of securities with similar characteristics, attributes and risk/return relationships. Broad classes divide further: bonds into treasury, corporate and junk; equity into large cap, mid cap and small cap.

The allocation is the starting point for the investor, and it follows from the client rather than from the market — goals, the time available to reach them, risk appetite, liquidity needs. Choice of individual products within an asset class matters, but contributes far less to the end result than the overall allocation does.

The long-term view of how much equity is strategic asset allocation; the short-term tilt around it, taken to exploit a market opportunity, is tactical asset allocation.

The machinery underneath is correlation. Securities within one asset class are sensitive to the same major economic and investment factors, so correlation inside a class is high; correlation between two different asset classes is expected to be low. Correlation coefficients run from −1 to +1, and it is the low correlation across classes that produces the risk reduction. Correlations change over time and in different economic regimes, so past correlation is not a safe sole input.

The empirical support is specific and examinable. Brinson, Hood and Beebower (1986) concluded that a portfolio's target asset allocation explained the majority of a broadly diversified portfolio's return variability over time, and Ibbotson and Kaplan (2000) confirmed it. Across all portfolios, the asset allocation decision explains an average of 40% of the variation in fund returns; for a single fund, it explains 90% of that fund's variation in returns over time.

Once set, an allocation drifts, because asset classes earn different returns. Rebalancing restores it, and the Investment Policy Statement should say how often and how much — the periodicity, and the tolerance for deviation from the target policy portfolio.

A 38-year-old client has a corpus of Rs 60,00,000 and an agreed policy portfolio of 60% equity, 30% debt, 10% gold.

A year passes. Equity returns 28%, debt 7%, gold 12%. Nobody does anything.

The client is now carrying four percentage points more equity risk than he agreed to — not by decision, but by drift, and precisely because the risky asset did well. Restoring the policy portfolio on Rs 72,06,000:

Equity target = 60% × 72,06,000 = 43,23,600   → sell Rs 2,84,400
Debt target   = 30% × 72,06,000 = 21,61,800   → buy  Rs 2,35,800
Gold target   = 10% × 72,06,000 =  7,20,600   → buy  Rs   48,600

That is the trade. It is also, deliberately, selling what has just gone up.

The reason it is not done every month is cost. Rebalancing carries transaction cost (brokerage, research, time), tax cost on the gains realised in selling the appreciated asset, and an opportunity cost — equity may keep running after you have trimmed it. The trade-off the workbook sets out is simply the cost of rebalancing against the cost of not rebalancing, which is why the frequency and the tolerance band belong in the IPS, agreed in advance and in writing, rather than being argued about after a good year.

Chapter 15 (Portfolio Construction Process) — section 15.1 on the importance of the decision, 15.2 on correlation across asset classes, 15.14 on the allocation decision itself, 15.16 on strategic versus tactical, and 15.17 on rebalancing. Expect the Brinson/Ibbotson percentages as a direct recall question, the definition of an asset class, why correlation matters to the decision, and the rebalancing trade-off.

• Allocation is not diversification within a class. Holding thirty large-cap stocks is cross-sectional diversification inside equity; it does not change the equity weight by a rupee.
• The two empirical numbers answer different questions. 40% is the variation explained across portfolios; 90% is the variation in a single fund's returns over time. Questions swap them, and both figures appear as options.
• It explains return variability, not return level. The finding is about variation, not about how much money the portfolio makes.
• Correlation is not stable. Two assets that diversified each other for a decade can move together in a crisis — exactly when the diversification was needed.
• Rebalancing is not automatically right. Transaction cost, tax cost and opportunity cost all weigh against doing it often, and illiquid holdings such as private equity and real estate are much harder to rebalance than listed equity or government bonds.
• A market view is not asset allocation. Acting on one is tactical asset allocation, and it belongs inside the strategic framework rather than in place of it.