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Asset Allocation | Portfolio Yoga

Category: Asset Allocation

Save Early or Lose Substantially?

An often repeated mantra is that if you don’t start saving early, you end up losing tremendously. You cannot argue with a statement like that , especially when it’s backed by evidence of the difference in returns if you start at 20 or start at 30.

Keeping in mind my skepticism with much of what goes around as “gyan”, I made this kind of sarcastic tweet in reply to one such tweet. Now, just to be clear, I hold Dinesh in high regard for his understanding of Finance and while I did use his tweet as material to push my agenda, it has nothing to do with him perse.

https://twitter.com/Prashanth_Krish/status/1327548992037609472

Kids in the US are burdened by Education Loans they take. The burden is so heavy for some that they would need to keep paying off till retirement. So, why do they even bother? The reason is simple – higher the education, more the remuneration and lower the possibility of being unemployed

https://twitter.com/Prashanth_Krish/status/1327624954192412672

One would rather be employed and paying off debt than unemployed with no debt but no optimism about the future either. While I don’t think that education in itself is everything, it’s a foundation that can help a lot. 

Let’s go back to the original tweet. What is seen is the difference in outcomes based on a straight line approach to savings. If you start saving at 20, you are way better off than someone who starts to save at 30 assuming both end at 60. This is not surprising and it’s not just about compounding effects. Person A is saving for 40 years versus Person B who is saving for 30 years. 10 years of savings and the compounding does matter as the chart below shows

There is a very big hidden assumption here. Not only is Person B starting at 30 which is 10 years later than Person A but he is investing the same starting capital. What if rather than invest 10K per month, he is able to invest more?

When he is 30, Person A is investing roughly 16,300 per month (10,000 per month with an increment of 5% per year). If Person B starts his year 30 by investing 31,800 per month (close to double what Person A is investing) which too increments by 5% per year, this is what the chart looks like

Basically, by starting with a higher number, Person B despite starting late is able to catch up to Person A. 

But he is investing more, you complain. This is true. My assumption is of course that he has not whiled away his time between the age of 20 to 30 but gathered either diverse experience which helps him earn more or got himself a higher degree which provides a higher salary and hence even with a similar savings rate is able to save on an absolute terms a higher number.

But lets equalize it in a different way – let’s assume that both work for the same period of time – 30 Years. Person A hence retires at 50 while Person B retires at 60. When Person B starts to invest, we assume he will invest the same amount  per month that Person A is investing at that point of time and increment 5% per year. Where will they be when they hit 60 years of age?

We are back at Point 1 though slightly better. Person B trails Person A by nearly 50% even though Person A has retired a good 10 years earlier. 

But there is another assumption we are overlooking. We are assuming that both of them get similar returns. How much of a higher return should Person B get to catch up with Person A at the age of 60?

The answer to that is 15%. If Person B can get 15% per Annum vs 12% per Annum for Person A, at 60, both of them end with a similar capital.

Here is the interesting thing. Both Person A and Person B can expect 15% from Equities and still end up at the same outcome at the end. The difference though would come from Asset Allocation. 

While Person A can have a 60 / 40 Asset Allocation in favor of Equities and reach the number as Person B who is forced to have 100% in Equities. In other words, though both have similar return expectations from Equity, the allocation they need to take will be different. 

For Person B to have the same outcome as Person A with the same Asset Allocation, he will need to generate 20.3% from Equities – something that very few have been able to achieve in the long run.

On the other hand, Costs can play a large role in the final outcome. Assume both invest in Large Cap Equity but Person A invests through a Mutual Fund Distributor in a Active Large Cap Fund whereas Person Invests in a Large Cap Index Fund / ETF. 

While both of them will hold a similar portfolio {minimum of 80% matching}, Person A is paying a 2% fee vs Person B who will end up paying 0.10%. That is a straight forward gain of 1.90% and actually reduces the requirement for Person B to outperform Person A by that much. To get 15% returns in Equity after fees, Person A has to have a fund that delivers 17% vs Index fund Returns of 15.10%. If you have looked at SPIVA data recently, you shall notice that most Large Cap have it hard beating the Index let alone by that margin on a long term.

When we were young, we were taught the concept and Importance of Savings by stories such as the Ant and the Grasshopper. I don’t think we should deny the importance of a disciplined saving from an early age. But is everything lost because you started late though the barriers are higher. 

While I do like the message of saving early being good there is nothing to be scared about if you started out late. Finally, it’s not the amount you have at 60 that really matters as much as the quality of life you have lived. The very fact that you are reading this puts you into the 10% of the population and one that is most likely to succeed as well. 

Want to Stress Test your Retirement – check out the simple calculator(s) here. Of course, the assumptions build in here are US related, but should give you a chart of how other paths than the one excel plots.

The (in)ability to Act

There is a famous saying by Mike Tyson

Everybody has a plan until they get hit. Then, like a rat, they stop in fear and freeze.

As Investors, it’s easy to quote 

Buy when there’s blood in the streets, even if the blood is your own.

Baron Rothschild

but as another famous quote goes

In theory there is no difference between theory and practice, while in practice there is

When we talk about markets, we generally refer to the large cap Index – Nifty 50 or Sensex as the indicator of how good or bad the markets are. While the Corona Virus has brought down markets around the world by a notch or two, the fact remains that this fall is nowhere if compared to earlier falls that have been seen by the Index.

Take a look at this historical draw-down from the peak chart. At just around 10%, this fall is nowhere in comparison with even the falls of 2012 or 2014 let alone historical falls. In a way, if history is any guide, this is the start and not the end of a correction.

Nifty Drawdown from Peak

But, Nifty 50 for a while has not been the correct way to measure market sentiments. While Nifty 50 was hitting new All time Highs, more than 70% of the stocks that are traded on the exchange were trading below their 200 day averages

To get a better sense of the market, I created an equal weighted index of all stocks. Do not that its equal weighted in price terms and not on the basis of market capitalization. The overall market seems to be down by around 14% with the bottom made in October 2019 being in a similar range of the draw-down that we saw in mid 2013.

Draw-down from Peak of Equal Weighted Market Index

Don’t catch a falling knife is another quote that is used during market downturns. Then again, if the final destination of the falling knife is your foot, that risk may be well worth taking.

I am a strong believer in buying momentum when it comes to stocks but playing contrarian when it comes to asset allocation. This means that you should be wary of adding money into equities when markets are rising and wary of withdrawing money from equities when markets are falling. 

Having been in the markets since long, one observation I have been able to make is that while pre 2008, rarely did people refer to the crash of 2000 as something that could reoccur, despite the passage of 12 years from the time of 2008 crash, every fall is looked at as maybe the start of the next great melt down similar to what we saw in 2008.

Indian markets history is very small which makes it imperative to look at Dow Jones which has the longest running un-interrupted Index since 1896. Most of us have at max a 30 year period of Investing. 

If you had started your investment journey in the US in 1902, at the end of 30 years, you would have been negative at the end as markets buckled down destroying years of hardwon growth. The low of 1932 was the same level as was seen in Dow Jones was in 1896. 

An investor who invested in the depths of the great depression and let the investment grow for the next 30 years on the other hand gained a return that was not seen by investors until the investor of the 1970’s

End Result of a Buy & Hold of the Dow Jones . X Axis is the Investment Date, Y Axis represents the return for the same 30 years later

One of the toughest things when it comes to finance and investment is to be able to stand against crowd thinking. Right now the crowd is basically wondering if this is just the beginning of a bear market. 

Purely going by the 200 day Moving Average as the line in sand between a bull market and a bear, we are in a bear market with all major indices now trading below. Then again, if you were to observe historical data, the 200 day average has been violated once too many.

A much more stabler and better alternative seems to be the 200 Weekly Average (approximately average of 4 Years). Here is a chart that plots the difference (in percentage terms) between the 200 Week Average of Nifty 50 and Nifty 50 itself.

Whenever blue has turned to red has generally tended to be a good time to invest but not every fall resulted in index dropping into the red zone. In fact, during 2004 when markets tumbled post the election defeat of NDA, even the unseen lows did not test the 200 DMA.

What this means is that if you wish to invest more into equities, waiting for the bottom may prove to be a wait in vain if markets take off without providing one such an opportunity. On the other hand, it’s always advisable to have some dry powder if such a situation emerges.

So, how do we deal with such a situation?

This is where Tactical Asset Allocation comes into play. Unlike traditional asset allocation where the view is to stick to a single allocation and relook at the same once a year or once in 2 years (or as a AMC head recently tweeted, once in 4 Years), the advantage tactical offers is the ability to move higher or lower depending on the situation at hand.

In Bull Markets, we are comfortable with a higher allocation to equity (even musing if we should have risked even more) while in Bear markets, we wonder why we are so high on Equity. The ability to act against the trend is neither simple nor easy and yet acting in line with the crowd while it offers ability to share the happiness in good times also means sharing of sorrow in bad times.

While being too early is as wrong as being too late, we all need to act at some or the other point and if you cannot, your returns will match your expectations or even market returns. Our inability to act during opportunities is because of the fear that we may be too early. Based on whatever data we have, I believe that is not the case. Yet, markets could fall more and hence going all in at the current juncture is not a good idea either.

Stagger your investment to predetermined levels based on either your own portfolio draw-down or the market and act on it. The other day I tweeted out saying that the worst case, I am expecting a 20% dip from here for the large cap and 30 to 40% for the Mid and Small Cap. But that may or may not happen.

Based on the above thesis of mine, my strategy is to stagger so that I can invest / move a part of my capital from Debt to Equity at every X% fall in my portfolio. If markets fall to my worst case scenario, I expect to reach the maximum allocation to equity I am comfortable with, else, I shall still continue to hold Debt higher than the lowest allowable level.

There will always be regrets, the question though is which regret is better to live with and which is not. No one is going to tell when the bottom is hit but having a plan (preferably written down) can go a long way in helping you act when the opportunity arises.

Debt – Invest in Long Term Funds or Short Term

In 1996, IFCI came out with Family Bonds. OF the many options it provided, one that interested me and one I had my family invest was Millionaire Bonds (Option 1) with a face value of 10,000 per Bond. 

As the name itself proclaimed, an investment of Ten Thousand would result in a final maturity amount of 1 Million. The investment itself was a no brainer despite my own lack of knowledge on interest rates. IFCI being a government owned company meant no credit risk and a Million Rupees is a Million Rupees.

The bonds would compound at a rate of 17% annually and at the end of 30 years would yield the investor the final maturity value of 10,00,000.00. The bonds if they were still in force would have matured in 2026 and while a Million Rupees these days doesn’t seem as much as it was seen in 1996, it still is a solid amount. 

Unfortunately for the Investors, the Bond also had an early call option which IFCI exercised and redeemed the bond in 2003 for a princely sum of Rs.30,270. So much for the Million Dreams that got shattered.

Today when interest rates at Banks are close to 7%, a 17% interest rate of the past seems like something that may never come back. Today even 7% appears to be mouth watering when we see the interest rates in european countries where you need to pay an interest on your deposit to the bank rather than the other way around.

Unlike in 1996 when there was no opportunity to lock-in funds for decades ahead, today we have such an opportunity in the form of 30 year government treasury bonds. If you don’t have taxable income, you are able to get an regular interest income for the next 30 years.

But if you are like most employed and have a taxable income, the returns are sub-par post accounting for the taxes (higher your bracket, lower the returns). Thankfully we do have Mutual Funds which can Buy and Hold such securities while income is recognized on your books only at the time of selling.

The biggest advantage of buying long term gilt is that you are locking in the interest for the future. But this can work either way. In a falling interest rate scenario, your investment like the IFCI bond would turn out to be an amazing winner.

Yet, the risk  is as high if not higher. In neighbouring Pakistan, Core Inflation in 2015 dropped below the 4% mark. Like us, it came even as GDP growth rate fell. This was a steep fall from the  17 percent inflation that was seen in the country in the year 2007-08. Interest Rates followed suit with the Central Bank slashing the rates to a 42 year low of 7%.

Today, Pakistan Inflation of 14.6% is the highest its been in the last 12 years. While most countries interest rate is going down, the Central Bank has been forced to hike it up to 13.25% (double the rates it had seen just 5 years ago).

Mutual Funds love selling longer term funds. The expense ratio for a Medium to Long Term fund is 5 times as expensive as a simple liquid fund. Based on current assets under management, I see very little interest in such funds {Ignoring for Liquid AUM, Medium to Long Term funds have been able to capture just 0.78% of the total assets}. 

Investing in Long Term Bonds requires a view on the interest rates and is not a Buy and Hold investment for if things go bad, you will end up not having any return even after years of being invested.

Thanks to the recent downmove in Interest Rates, 1 year Gilt returns looks extraordinarily good and this is starting to show up as interest both from advisors and retail clients. Jumping in now can be beneficial if interest rates continue to trend downwards, but if they react upwards, you would be in for a really long wait.

Short Term Funds carry the risk of reinvestment at lower and lower rates if interest rates continue to go down. But if they rise, they quickly start getting higher returns since the bonds are of short tenure and reinvested at a higher rate.

For a small investor, Debt funds are and should be used as Capital Protection for the rainy day. The real growth though shall come from Equity and hence the importance of asset allocation. Trying to generate Alpha through Debt is fraught with Risks that need not be taken in the first place.

Backtesting Asset Allocation

Asset Allocation is the cornerstone of every investor. A good asset allocation is something that allows you to comfortably sleep at night. A bad asset allocation on the other hand gives you heartaches with higher volatility while not exactly meeting your goals either.

When it comes to basic asset allocation, you can go in two ways – the fixed method where you decide on an split between equity and debt and keep it that way by re-balancing once a year or go the tactical way with your asset allocation dependent on other factors – how cheap or expensive the market currently is for example. The Portfolio Yoga Allocator is a tactical asset allocator.

These days I find asset management companies pushing towards Hybrid funds as a way to smoothen the volatility. A few years back, the same funds were being pushed as a superior investment owing to their continuous dividend paying policy which provided cash flow to the end customer. When the markets change, I change my Narrative. What do you do, Sir 

Across fund houses, as on date we have 180+ schemes that match the Hybrid / Balanced fund category managing over 3.8 Lakh Crore. The wonderful part of the whole equation is that they charge asset weighted around 1.65% for the pleasure of providing you some level of asset allocation split.

While the choices are many, just 28 of the 180+ schemes account for 80% of the total assets under management with HDFC Balanced Advantage Fund being the biggest of them (11.6% of total assets).

In the United States, Vanguard offers portfolios with fixed asset allocation split with expense ratio being below 0.10%. Interestingly you can devise your own fixed asset allocation portfolio here in India with the end cost being just around what Vanguard is providing its US clients.

SBI ETF that tracks Nifty 50 for example has an expense ratio of just 0.07%. While there has been Liquid Bees that has been in existence for long, Axis Liquid with assets under management of nearly 30 thousand crores and expense ratio of 0.11% is just as suitable.

Our goals are dependent on the future growth of our portfolios and while fund managers talk about high expectation of return, I for one felt that looking at the past data should provide us with a clue on what we should expect in the future.

For this exercise, I have chosen Nifty Bees as proxy for Equity and HDFC Liquid Fund as proxy for Debt. Portfolio’s was created in January 2002 and rebalanced once every year. The rebalance was subject to a variation of 5% from our target allocation. For instance if Equity shot up during the year and we ended the year with 65% Equity and 35% debt vs starting point of 60% Equity and 40% Debt, the additional equity is sold off and used to buy Debt to bring it back to the 60/40 ratio.

60 – 40 (Equity – Debt) Rolling CAGR

First up is the predominant asset allocation split. 60 / 40 is universal & the simplest asset allocation with a slight tilt towards equity. Do note though that since we have 60% in equity which is of much higher volatility than debt, if you were to measure the asset allocation in terms of volatility, this would seem more like a 80 – 20 split.

As on date, the 3 Year CAGR for this mix comes to 11%, its 7% for 5 years and 9% for 10 Years.

We measure risk by looking at the composite draw-down of the portfolio from the peak. As the chart below shows, most of the time the draw-down was limited to 10% or lower with the maximum being seen as expected in 2008 when markets dropped more than 50% and this portfolio dropped around 25%

Inverting the Ratio – 40 – 60 (in favor of Debt)

What if we tilted the ratio in favor of Debt vs Equities. How would that impact the returns and the Risk?

The chart below plots the same and as can be observed, the difference is minor. But do note that compounding on the long term can meaningfully change the end values for a 60/40 split vs a 40/60 split if the equity premium continues to remain strongly positive.

With Equity taking a back-step, we see a slight reduction in the draw-down as well. 14% is something one can live with given the rarity of such events.

The Aggressive Investor – 80 – 20 Split

If you are young with limited savings and a long road ahead, you may opt to be aggressive when it comes to equity allocation. While you can always go with a 100% allocation to equities, given the uncertainties in life, having a small allocation to debt can help during the bad days.

There is no free lunch and a 80 – 20 Asset Allocation also has a higher draw-down and higher volatility. But at the right time, high allocation to equity can boost your returns significantly.

The Reluctant Investor, 20 – 80 Split

But what if on the other hand you are retired and dependent on the savings for the rest of your life. You wouldn’t want to take unnecessary risks. Yet, with dropping interest rates, it does help to have a small allocation to Equities that can push up the overall returns in good years while not dragging them down substantially in bad years.

Thanks to the fact that our equity exposure is just 20% and one that is re-balanced regularly to keep in shape, the draw-downs is something you can sleep comfortably with even when the rest of the world is seemingly jumping off the ledge.

Asset Allocation is specific to each individual, this goals and his risk taking capacity. While we all wish for the largest gains, we cannot easily digest the large draw-downs that occasionally come with it.

Panic is certainty for everyone of us, but with the right allocation rather than panic we can take advantage of the opportunities provided by the market.

Before I conclude, lets take a look at the Equity Curve of all the above allocation strategies. It goes without saying that higher the equity exposure, better the end result.

One observation from the data is that returns are trending down for a long time now. While the future maybe bright, this data to me provides a perspective on what is possible and what is not.

Compared to fixed, I continue to believe that tactical can provide you with a larger advantage but since its requires monitoring of a regular nature and one can go wrong as well, its not everyone’s cup of tea.

Hope this post provides you some food for thought on how to approach your asset allocation from the perspective of future returns. If you have any queries, do drop me a mail or comment below.

How to plan for your Retirement if you don’t have One Crore Rupees

The other day I was reading a blog post where the author claimed that even 1 Crore in savings is not enough to sustain a good life (assumption being monthly expenses of 50K per month). But how many (I am sure that if you are reading this, you have already reached the 1 Cr mark in savings or sure you will) folks in India can really save that kind of money. 

In ways more than one, we live in our own bubbles. Unlike the West, we have very little to speak off when it comes to Social Safety Net. Costs are ballooning even as opportunities for income become weaker by the day.

In the last couple of years, explosion of ecommerce has meant there has resulted in a huge number of low pay jobs. While it was easy to make fun of Pakoda making as being an Industry, being part of the gig economy is worse for you learn no real skills no matter how long you work nor build any brand identity. 

Retiring at 60

When we talk about Retirement, most instantly think about  their job ending when they come to 60 years of age. But why 60 and what is the history behind Retirement.

Retirement is a very recent phenomenon thanks to 1. Growing population that meant you had more people available for work 2. Longer life expectancy and 3. Changes in technology which meant the older generation had to constantly keep learning new tricks 

Frederick Hoffman argued in 1906 that a country’s productive potential could be maximized if people ceased working at age 65. While we are mentally as active at 70 as maybe at 60, the physical abilities deteriorate over time and unless one is in the knowledge based industry, its rare to see active senior workmen on the floor of any factory.

Life Expectancy in India

India’s life expectancy has been trending higher and given both the advances in healthcare and quality of lifestyle means that should expect the average to move higher. 

Unemployment has always been India’s bane though for few periods of time, we have had the kind of growth that made it seem that maybe finally we were able to come to grips. 

Social Security is a major source of retirement income for a large swath of Americans, but in India, one is left to their own. This means that if you stumble during your earning years, it tough if not impossible to build a retirement nest that can last your lifespan.

By 2050, the United Nations estimates that one out of every six people—or 1.6 billion—will be over the age of 65. In Japan, a country which is rapidly ageing, 59% of men ages 65 to 69 are still working. 

Aging across Countries

A year ago, I had an acquaintance ask for my help in figuring out if he was on the right track. This Gentleman had 3 Crore plus in savings but had a pretty hefty monthly requirement. He had gone with a very large wealth management firm a year before that and was seemingly not sure he they were guiding him right. 

The portfolio he showed me had the following funds with his funds split across them.

In addition, he had just been switched out of 3 funds and into 3 others. Thanks to the switches, in addition to getting ripped off in Dividend Tax, he was paying Income Tax on top of it as well.

So much for having some-one plan your finances. Of course, he wasn’t alone as data for flows into Balanced Funds showcased. Investors were sold the concept of being able to get monthly dividend even as the overall value of their holdings increased over time, a win-win situation. The only winners were those who sold thanks to the nice commissions.

I have this friend who has worked for a while and been an entrepreneur for another length of time and currently if he goes by the hippie slang, he is between jobs. He recently came to me asking for advice on how to go about investing the money he has while ensuing some kind of security for old age.

While I am not a Certified Advisor, given the bad experiences I have come across plus the fact that his corpus was way too small for most advisors to make it work commercially, decided to create a plan that allowed him to get a monthly income.

But was I on the right track, did I miss anything. Thoughts of these made me tweet to get reactions from those who follow me on Twitter.

140 plus responses were received and I am thankful to each of them for taking some time out to think and respond to a real problem that required a good solution.

Due to the nature of request – monthly income combined with fact that the person had too less money to work around, many responses were similar in nature.

Selected Tweets with my views on the same

An Interesting suggestion this was. IDFC First Bank offers 8% interest on 3 year deposits. At 20 Lakhs, this would generate what he wishes while the investment in Large Cap would enable a bit of compounding at a higher rate (hopefully). Even better would be buying ETF’s of Nifty 50 and Nifty Next 50 since tests have shown that they can generate as much return or sometimes even better than the best large cap fund.

https://twitter.com/iarm87/status/1172902709004910592

What is a Balanced Advantage Fund?

Balanced Advantage funds are funds that invest 65% into equities and 35% into debt. The advantage here is that since it has 65% into equities, its treated as Equity for tax purposes.

The disadvantage, since 65% is in Equity, 90% of its movements are correlated with Equity. Equity returns being chunky in nature, this is not the best instrument for having monthly returns.

This is a very interesting scheme and while my friend is not eligible since he is not yet 60, locking in 15 Lakhs with return of 9.60% (taxable) is something that is worth looking at for those above the age of 60.

https://twitter.com/reachanandl/status/1172881192334454784

Maximum number of suggestions were to invest everything at Bank and enjoy the fruits. The positive is that the monthly income for now would be more than what he requires enabling him to save and add to the principal

The negative is that there is Re-investment Risk. If interest rates are lower at the time of renewal, he would have to start cutting expenses which would have gone higher thanks to Inflation or start eating into the principal – not an enticing prospect.

This is something I actually discussed with my friend. While he too wants to be active and not just sit at home, the tough part is that very few skill sets have ability to generate an income without having to risk capital for he has none.

Have talked to him about a couple of areas where he could start off and while income may not be visible immediately, who knows what tomorrow holds. Fingers crossed for now.

https://twitter.com/anilbajpai/status/1172848258869153792

Another common suggestion was Reverse Mortgage. While I did’t explore this idea with him at current juncture, its something that hopefully shall catch on. SBI eligibility for Reverse Mortgage is 60 years and while his house being in the suburbs may not yield a great amount, its still something that can be accessed if circumstances so demand.

Cost of Healthcare is a real issue especially given that as one gets older, the risks get higher while premiums shoot up making it immensely tough to be insured.

Friend has Health Insurance for now, but bigger question is, how much is enough. Not an easy ask balancing the requirements with the cost of taking that hedge.

One of the interesting observations was that he retired early by choice. I wish not to go into the circumstances on why he is Retired before he has accumulated a Crore other than to say “shit happens”. Life doesn’t go according to one’s plans and wishes.

As much as the suggestion is valid, as one gets older, he wishes to stay close to his near and dear ones. After all, emotional security is as important as financial security.

Overall, diverse suggestions and once again, thanks for chipping in. Was especially moved by this tweet

Thank you Sridhar for your thoughts.

What I felt was missing was the concept of “Safe Withdrawal Rate”

While this is more applicable in countries where the government ensures that your ailments don’t need you to sell your house, even in India post a certain age, it makes sense to think about withdrawing from the Capital itself.

This especially if low interest rates have made it tough to meet ends. Risk though is that you run through your capital before life runs out.

The whole exercise has been interesting enough for me to wipe the dust off the CFP books I had ordered a while back. As for my friend, I think he will get along okay.

Prudential Asset Allocation

Few days back, this tweet by Muthukrishnan caught my eye.

While I have used the tweet of @muthuk, my views below are not with respect to him. I believe there are hundreds of such examples but not highlighted.

A genuine advisor starts investment counselling process by concentrating on the asset allocation mix. These days, the only advisors one hears about is those who start off by recommending what they believe is the best fund to invest in.

Asset Allocation is the foundation on which you build the structure. In good times, read as when markets are bullish, advisors would rather first build the structure and only then think about if any foundation is required.

Asset Allocation is personal – my allocation mix is suitable to me only. It’s not possible for others to coat tail or just copy. Being personal unfortunately works against for when we don’t even disclose all the details to our Doctor, providing our financial position to an adviser is an unknown concept.

This has meant that the advisor is working with data that is not full and hence liable to make mistakes. Assume for instance a client walks in and says that he wishes to invest in Equity, a distributor with little or no data on his other assets can only provide him a list of funds he believes are good investments.

As an analogy, think about going to a Chemist shop and asking for tablet for fever. In all likelihood, he would disburse you with a strip of paracetamol. But what if you are experiencing fever accompanied by shivers. That would require a different approach since shivers come for specific reasons that paracetamol alone won’t help.

In India, main stay for Mutual funds are distributors who are by SEBI disallowed from advising on asset allocation. They can only give incidental advice and this is restricted to selecting MF schemes for investment. In other words, they are more of a Chemist than a Doctor who can diagnose the issue properly and provide the treatment necessary.

If you are not invested in equities, its seen as if you are missing out. Fear of Missing Out happens even more in bull markets, but not everyone requires equity exposure in the first place. Let me take a couple of examples where you maybe better off with Debt than Equity.

If you are a business owner, you are already upto your neck in equity – just that its your own firm’s equity that is most of the time pretty illiquid. Business fail all the time and while I don’t have data, I think there is a very high correlation between failure and the state of the economy.

When things are good, your investments are good, your business is good, life is great. When things turn rough in the market, market goes down, your business goes down and your life suddenly sees a different trajectory.

Being a Chemist and Druggist is a wonderful business. It comes with certain moats that have made it tough to disrupt in the way other businesses have been disrupted. Yet, disruption is always round the corner for who knows what the future holds. 

A chemist I know has invested in savings in buying a commercial complex that yields a sizeable rent. This has ensured that even if tomorrow his business is somehow disrupted, his life can go on as usual thanks to the continuous cash flow.

In other words, he has invested in what can be compared to Dividend Yielding stocks that may not give much capital appreciation, but can provide good cash flows over time. While Real Estate is looked negatively from the angle of asset allocation for being a dead asset, for him this is as good as equity with only draw-back being it is illiquid in nature.

Buying a house these days invariably means taking a loan with monthly EMI’s eating substantially into ones earnings. Thanks to the tax treatment, it may seem to make sense to take loans these days than save and pay by cash. Yet, how do you treat the loan has large implications when times are bad.

The biggest fear than most young employees express is the risk of layoff’s since many are burdened with staggering amount of loans – from Mobile Phone to Cars to Homes and what not. 

In 2006 / 2007, Americans had bought homes on loans. While the focus for long has been about loans offered to people who had no credit history or even ability to pay back, a lot of loans were also to people with steady jobs.

When the financial crisis erupted, it not only brought down housing prices but also meant loss of jobs. Take a look at the change in Unemployed Rates during that period

If one was invested in addition in equities, he saw his portfolio cut by 50%. Its easy to ridicule those who sold equities near the bottom, but if one had lost his job and his house at risk of being possessed for not making the monthly payment, better something than losing everything.

A friend of mine was recently asking about how he should treat his house in his asset allocation mix. Thinking on the same, I believe that if there is a loan repayable, you are better off treating it as equity than as fixed asset which is what it is.

Advisors to Fund Managers use the Warren Buffett quote 

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

While we can summarize the quote as one about how long term is rewarding in equities, another way of looking at is that if you need money over the next 10 years, equities may not be the best bet.

That doesn’t mean that you need to have zero exposure to equities, but given the fact that India is one of the few countries where you can get real positive returns on Debt, its unwise to load up on Equities if the objective of the investment is to help you in times of distress.

Have a prudent asset allocation plan that plans for worst case scenarios. Debt while not seeming sexy as equities can actually deliver better results if you face volatility in your career.

Assets can be temporary, Liabilities are permanent. Stress test your allocation to ensure that a quotation loss doesn’t become a permanent loss. As a quote goes,

A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain. 

You don’t want to be without an umbrella when it starts to rain.

Asset Allocation & Models

In 2015, I wrote a small post introducing the Portfolio-Yoga Asset Allocator.

Introducing Portfolio Yoga – Asset Allocator

While the model in itself has undergone a change once, given the dichotomy with the current allocation and the market trends, I felt that a post was required to help better understand the model and how to use it as a guide for your investments.

I am a strong believer in systematic rule based models for these enable one to test out the nature of the idea before committing money or time on the same. Yet, the single point of failure for most models lies in the developer of the model himself. Models are build in two ways – one by way of data mining the past and coming up the optimal combination that seems to generate the best possible return.

The risk of such models is that the future is not a repeat of the past. As a wonderful quote goes, “History doesn’t repeat itself but it often rhymes,”. While human behaviour will ensure that we never really run out boom and bust cycles, the length of cycle will keep differing making even the most data oriented model but one that was trained on a different cycle length go repeatedly wrong.

Asset Allocation models aren’t really different – at the core, the philosophy is that you get the best “Risk adjusted Return”. That doesn’t mean one never goes wrong, but when one goes wrong, its better to err on the side of caution that on the side of Risk.

The model offered here is contaminated by the bias I bring to the table. While in my own investing, I was never conservative, owing to the experiences of self and clients, I have come to believe that its better to be safe than sorry.

The simplest asset allocation split is 60:40 in favour of equities. But when you adjust it for risk, you are actually looking at 90:10 and to me, that requires tremendous will power and experience to be able to row through a tough time with such a massive tilt.

Much of the literature on Asset Allocation comes from the United States but one that is uniquely different from the Indian markets. Interest rates in US have been low for a very long period of time and given the rising cost of living, especially Education and Healthcare, Investors are forced to risk more than what they should or rather would want to risk.

Since , Interest Rates in the United States have hovered close to the 0% mark and this means that Debt (Short Term Bond Funds) have yielded just around 3% for the end saver. Equity on the other hand has been in one of its longest bull runs with CAGR since the start of the rally in 2009 being to the tune of 17.75% {Total Returns}.

In India, Debt has yielded around 8% versus 16% for the similar period. Equity does deliver more, but that is also more a function of where we started at. If we had moved it back to just a few months back, January 2008, the Equity returns falls to 5% while Debt would be barely change much.

Investing in Equities is a game of timing. Invest in a good time and returns shine while on the other hand, investing in bad times can result in long periods of under-performance and even long term persistence may not change the end result by a great deal.

The highest correlation between factors of today and returns of tomorrow lies with Valuation which is a key input for most asset allocating algorithms. One of the better known valuation model is Robert Shiller’s Cyclically Adjusted Price to Earnings Ratio which tries to use a longer average of returns and hence avoid pitfalls of short term variation in yearly numbers.

The logic behind the Asset Allocator I update here is similar in approach. Since valuation is relative in the time space continuum, I use historical data to try and smoothen the curve. This ensures that the model is not binary in output.

Using the Asset Allocator Model

Asset allocation at its basic is about two things – Time and Return, Return being a product of time and valuation / growth. Both of these factors are hence the bulwark of the model.

Regardless of where valuation is, if you don’t have time on your hands, it make sense to have a Conservative Asset Allocation. For example, assume your kid will go to College in 3 year from now – would you want to risk the ability to pay his fees on the state of the market?

Conservative is also for folks who aren’t able to get through a major draw-down in their Networth without it impacting their way of life. Loss affect each one of us in different ways, but if loss – even we anticipate it to be temporary will make you worry, you are better suited to a Conservative allocation – it will provide a much lower return, but at least, you aren’t losing sleep over it.

Between the short term goals and long term goals, you will encounter what are medium term commitments – something which is at least 3 – 6 years away.  Here, you can take a bit more risk than with short term for you have a bit more time on your hands.

Finally there is the Aggressive – Aggressive is a mode for those risk takers who understand what they are doing as also applicable for those whose goals are years away – Retirement for example.

One of the primary complaints has been that the Asset model even at the Aggressive mode is way too Conservative. Currently for instance, this stands at 20% Equity and 80% Debt. As a friend who is ultraconservative recently commented, even he had more equity exposure than what the model seemed to argue for.

In software parlance, this is not a bug but a feature. When the going is good, it’s easy to mistake luck for skill and be overly aggressive in allocation versus what one is comfortable with. Those who haven’t yet seen a bear cycle fall into such traps for long bull markets make even the ordinary investor seem extra-ordinary when you look at his returns.

Historical Allocation and Draw-Down’s

Old timers remember how the markets fell post the Harshad Mehta scam. Yet, the bigger draw-down came in 2008. The fall of 2008 means that any model needs to account for a probability of 65% fall in the future. Accounting for a high level of draw-down has a direct impact on returns too given the correlation most models have with regard to Valuation, Return and Draw-downs.

Nifty is currently down just 5% from the peak. Assume that 2019 turns out to be similar to 2008 and Nifty goes down 65%. With a 20% allocation, you have the possibility of seeing a maximum draw-down of 16%.

The chart below showcases the average draw-down and maximum draw-down you could experience at various levels of exposure.

The above chart is based on the historical data of Nifty 50 from 1991 to 2019. The maximum is the same as what we saw in October of 2008. The deficiency if one can call if of the chart is that its path dependent.

Standard Deviation is close to the average, so you can at most times expect anywhere between double the average or close to new highs.

Finally, the model is for Investors who aren’t experienced the markets and would like to have an understanding of how much to risk at the current juncture. As you gain experience and go through cycles, you begin to get a better understanding of how much to bet on equity.

For sake of simplicity, I am ignoring all other asset classes out here. I don’t believe that given our fascination for Gold, it makes sense to bet even more by buying Gold backed financial assets.

Asset Allocation isn’t a one size fits all. Each person needs to evaluate his own requirements, his time frame of thought, his risk temperament among others. If you think you aren’t really capable of doing all that and there is no harm or shame in asking for outside help – preferably a qualified Financial Planner.

But do note that it’s finally your money and it’s very important you understand the risks and rewards for the weakest link in any strategy is bound to be you. Even the best advisor cannot be of help if you aren’t prepared to take his advise.