Market correction or not, make your own unique asset allocation

Let's get started with what asset allocation is. Asset allocation means diversifying your investments across different assets like equity, gold, real estate, and fixed-return securities, among others. Asset prices go through cycles and having a diversified exposure allows you to safeguard overall portfolio returns when anyone is undergoing a downward return cycle.

However, when seen through a fund manager’s lens, this can be quite different from what individual investors need. To a fund manager, switching from equity to fixed income is a matter of asset price cycles and optimising returns given the trend. For example, in times when growth stocks are doing well, a value-style fund manager may increase cash in their portfolio rather than adding more expensively valued stocks.

Similarly, an astute advisor may focus on asset allocation shifts based on interest rate cycles, moving from debt to equity and vice versa. Until recently, capital market experts used to recommend more gold in the investor's portfolio, these days they suggest that the rally in gold price may be at its top.

If you did add more gold to your portfolio, should you sell now based on this asset allocation suggestion? If you sell, where do you reinvest? What about taxes? There is also opportunity cost if gold continues to outperform and the substitute asset you picked doesn’t.

Practical issues

Fund managers can switch assets quickly because the size of their investment is large, which makes transactions cost-effective. Also in a mutual fund structure, the tax implications are not the same as they would be for individual investors.

A regular investor is likely to face two practical issues if the asset allocation is based only on asset price cycles and requires quick shifts.

Firstly, there is the question of reinvestment. If one asset is looking overpriced you will sell, but where are you going to reinvest? Returns from different assets differ. For example, if you sell equity in a correction and opt for stable return fixed income funds or deposits or bonds, you are likely to earn a lower long-term return by disrupting the compounding journey of your portfolio. The latter are low-risk alternatives and returns are aligned similarly. Returns from equity are optimised over longer periods; staying invested through interim corrections in an 8-10 year investment period is critical. For fixed-income assets, credit cycles also matter in enhancing return, but relying on that can increase risk significantly; it’s no longer an asset allocation call based only on the return expectation. Moreover, you have to time the entry and exit to perfection.

Gold and real estate

If you were to choose physical assets like gold and real estate as a reinvestment when you sell equity, quick exits may be difficult when you want to move out of these assets. Let’s take a hypothetical situation, say there is a two-year correction in equity and you were able to time the exit perfectly at the market peak. You take this money and reinvest it in an under-construction property and gold. Two years later, the time to reinvest in equity assets is ripe as the market is turning around from the bottom, but your under-construction property is not ready, it’s taking time to sell and the gold you sell will incur a 20% capital gains tax.

Capital gains tax is the second issue for individual investors in making swift asset allocation changes. What can work better is asset allocation which is an outcome of your future financial goals, rather than a defined goal itself.

Create your exclusive allocation

Every investor will have varying financial goals and risk boundaries. Based on these you need to pick the assets that work for you. Your home-buying goal is better funded with a stable return, and low-risk assets if that goal is less than 3 years away. Similarly, your retirement goal is better funded by equity assets if that goal is more than 5-10 years away.

If you are a family of two adults in your 40s, with no children, you may be allocating more towards long-term wealth creation because your immediate expenses are likely to be relatively low and some of those financial goals of children’s education and marriage are absent. 

If you work for a company that operates in financial services and you hold a hefty portfolio of stock options or even shares, you may want to reduce your external equity investments as the risk in that asset is already high. 

If you are in your mid-fifties with a large accumulation in provident fund assets, you may choose not to have any investment in fixed return securities as your allocation is already high and perhaps several life goals are tick marked too.

Your financial needs should be the guide

Hence, how you allocate the type of asset you choose and the amount you invest in it is better guided by your personal financial needs and your overall risk-taking ability. Market trends and asset price cycles are not going to change your financial aspirations and personal risk.

Despite current expectations of a substantial correction in equity prices, it is not a good enough reason for you to switch your asset allocation. What you need to know is how asset prices behave across cycles, the asset risk, and the long-term return expectation so that you can make the most appropriate allocation choice.

Focusing on your personal finances is not as exciting as following the market trend, but it is what you need to do to fix an asset allocation that allows you to achieve your unique financial goals.