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Sunday, October 26, 2008

How to reallocate your assets

An investor friend asked me a million dollar question last week: The stock market has collapsed and blue chips are available at attractive valuations, but where is the cash to buy them?

Many investors - yours truly included - have been taken by surprise by the severity of the market decline. Let alone think about buying, many are scrambling to save whatever little is left of their portfolio. The currently attractive fixed deposit (FD) rates have prompted some to sell even at a loss and move to fixed income.

This is as great a time as any to give some thought to asset reallocation. But to do that we have to start with asset allocation.

Let us say that you are 35 years old and an investor in the stock market. The thumb rule for percentage allocation to equity suggested by market experts is (100 - your age). In this case, it will be (100 - 35 =) 65%.

Now you may not feel comfortable with the associated risk of such an allocation to equity. No one is pointing a gun at your head. Choose whatever percentage makes sense to you. 40-50% if you are a conservative investor. 75% if you are aggressive about making high returns with high risk.

The younger you are the more should be your equity allocation. Why? Because equities tend to earn the best returns over the long term, and when you start young you have less responsibilities and hence can afford to take more risk.

The older and closer to retirement you are, the more should be your allocation to fixed income. Why? Because the stock market can be in doldrums just when you are about to retire - when your regular income source will dry up. The (100 - age) formula comes in handy after all.

For argument's sake, if you agree with the 65% equity allocation (this could mean shares or equity MFs or a combination), the balance 35% should be in fixed income, gold ETF and cash. A rough breakup can be 25% in bank FD or Post Office MIS or PPF, 5% in gold ETF and 5% in cash.

The gold ETF is a hedge against inflation, but low returns may not permit a higher allocation. The cash is necessary for unforeseen opportunities - like a rights issue, or additional purchase due to a bonus issue or divestment.

If you have Rs 20 lakhs as an investible surplus, this asset allocation formula means Rs 13 lakhs in equity/MF, Rs 5 lakhs in fixed income, and Rs 1 lakh each in gold ETF and cash.

Investment guru Benjamin Graham had advocated that on no account should you let your equity allocation go beyond 75% or go below 25%. If you follow this advice to the letter and spirit, it will enable you to reallocate almost without thinking.

How? Say the stock market moves up (not likely in the near future!), and the value of your equity portfolio becomes Rs 18 lakhs. Your total investment value now becomes Rs 25 lakhs (=18+5+1+1), and your equity percentage becomes 72% (=18/25).

This is still below Graham's limit of 75% but is 7% above your original plan of 65%. Prudence requires that you start booking profits partially. If you are aggressive, you can ride the bull market till your equity value goes up to Rs 21 lakhs. Now you've hit the 75% level (=21/28). No further waiting - start selling and invest the proceeds into fixed income and cash, to return to your original percentage allocation plan.

What happens in the process is you increase your wealth in real terms - not only on paper, because now your fixed income/cash amounts have increased. The actual figures are about Rs18 lakhs in equity, Rs 7 lakhs in fixed income and Rs 1.5 lakhs each in gold ETF and cash.

Thanks to the bear market, let us assume your equity value drops to Rs 10 lakhs. Your total investment value is now back to Rs 20 lakhs (=10+7+1.5+1.5) but your equity allocation is down to 50%.

Guess what? You now have some extra cash to deploy back into the market. And if you opt for Post Office MIS and/or monthly/quarterly interest from your FD in your fixed income allocation - then you will have even more cash without touching your FDs or gold ETFs.

No wonder Warren Buffett has said that knowledge of simple arithmetic is enough to be a smart investor! (In real life, the arithmetic may become a little more complicated - but an Excel spreadsheet should take care of that.)


Ashish said...

Nice write up Subhankar.

Pondering over it, I think we should change some considerations:

not to take 100 (age) as denominator. Rather than taking the working tenure. Say, you are 35 and planning to work (to earn) until 50, Abiding to range of (25-75%); equity allocation would be:
= ((Work years planned - work years already over )/(Work years planned))* ( Equity allocation Range) + Lower limit of allocation in the range

say, if I am 31, started work at 30 and want to work until 50, abiding to 25-75% equity allocation range, then :
(((50-30) - (31-30))/(50-30)) * (75-25) + 25

...heck...getting lost in numbers...But its a great topic to debate and come to conclusions. Thanks for starting it.


Subhankar said...

That calculation did get a bit complicated! It is preferable to keep things as simple as possible.

The (100 - age) for the percentage equity allocation works pretty well. It is a thumb rule and can be changed, e.g. (110 - age), as per the risk tolerance of individual investors.

The minimum 25% and maximum 75% equity allocation was suggested by Benjamin Graham - an acknowledged investment guru. I have found it quite useful for periodic reallocation of assets.

Rishi said...


How does one approach re-balancing in case of equity market going down instead of moving up by the time one has invested?
For example what should one do when the equity value of 13 lakhs goes down to 11 lakhs, down by close to 15%?


Subhankar said...

Hi Rishi

Asset reallocation is something that you do once or twice a year. If the equity value goes down, the percentage allocation to fixed income investments and cash will increase. Use the cash to buy more equity. (If a really good opportunity comes, break an FD and sacrifice some interest to generate cash. But you can avoid this by opting for quarterly interests from your FD.)

Instead of looking for new ideas, I top up on existing stocks in the portfolio during reallocation.

sb said...

Dear Shubhankar ji,

Nice write up. learning new things everyday is exciting. I have a question. You said we should do this reallocation once or twice a year. My query is regd the tax angle. Would you suggest doing this once a year so that where possible we can make use of the capital gains tax free provision which won't be available otherwise?

Also, does this periodicity change in a bear v/s a bull market?

thank you

Subhankar said...

Thanks, Suraj.

Periodicity of portfolio reallocation should depend on each individual's investment style - regardless of bull or bear market. The reason I mentioned once or twice a year is to avoid the habit of frequent trading (which only makes brokers rich).

Regarding tax angle, please remember that taxes are paid only if you make a profit in the short term. If a stock runs up very rapidly within two or three months, it is better to book partial profit and pay tax on the profit. After 1 year the market may tank and all the profit may disappear. But there is no formula - other than the 25%-75% suggested by Graham.

Jasi said...


You have no idea how much research (googling) on this topic I have done. And I must admit, this article and the other article you have written on PPB are one of the best I have come across. The beauty of what you have written, which incidentally is the issue with everything I have read is, I can relate to it. Others are so vague that even after I read, I end up with some sort of emptiness. :) Not anymore. I really appreciate your effort.
I had a few doubts ...
1) How about LIC, ULIPs etc? Do they count as "investments" in debt? Personally I think no. Right?
2) How do I re-allocate my assets if lets say I have around 15k per month to invest? How do i go about distributing those fresh funds?

Subhankar said...

Appreciate the comments, Jasi.

LIC term insurance should be looked at as insurance only - not as an investment. ULIPs are a ploy by insurance companies to make money off investors.

For investing a fixed amount every month, follow your asset allocation plan. A portion should go into buying stocks or index fund units; a portion should go into a debt fund or a recurring deposit in a bank; balance should stay in a savings bank or a liquid fund.

Ek Veer said...

One of the best article I have ever come across. Thanks for sharing your knowledge.

Subhankar said...

Appreciate the feedback, Naresh.