Different asset classes behave differently at different times. Thus, an investor should invest in more than one asset class. Investing in different asset classes and products is called diversification. Let’s discuss in detail the importance of diversification and rebalancing and the ways to do it.
Diversification and rebalancing and their importance explained
Different asset classes like stocks, fixed income products and gold do not move in the same direction and at the same pace at the same time. Some asset classes may experience enormous volatility as well as a prolonged consolidation phase, so an ordinary investor is advised to spread their investable funds among different asset classes. There is no ideal asset allocation and may vary depending on your age, risk appetite and regularity of income.
A significant part of your portfolio’s performance depends on an appropriate asset allocation at all times. To ensure correct asset allocation at all times, it is also important for you to periodically review the performance of your portfolio and perform the corrective act of rebalancing the different asset classes to bring it back to the desired level. An ideal asset allocation should not remain static but should be dynamically changed as the person progresses in their career and age. It can also be kept dynamic in changing market conditions. Proper asset allocation along with periodic rebalancing helps you reduce portfolio volatility and maximize your portfolio return.
Why can’t an average investor perform proper diversification effectively?
Although you can invest yourself in different asset classes separately, it is very difficult to monitor, review and rebalance investments periodically due to your usual vocation, whether salaried or self-employed. Additionally, an average retail investor lacks the skills and knowledge to properly assess the future direction of various asset classes in the near future. Since to maintain the desired asset allocation, you need to rebalance your portfolio by producing some of your existing investments. Such churning may result in transaction costs as well as tax liability on profits made.
How to ensure asset allocation in a single product?
For investors who are risk averse or an average investor who lacks the required knowledge and time to decipher the direction of performance of different asset classes in the near future and execute rebalancing effectively may invest in various hybrid mutual fund products available. Some of these hybrid mutual funds come with investment limits specified by SEBI in various asset classes. There are products such as aggressive hybrid funds, conservative hybrid funds, advantaged balanced funds, multi-asset allocation funds, etc.
Readily available product with established track record
ICICI Prudential Mutual Fund offers an all-in-one product called ICICI Prudential Asset Allocator Fund of Funds that meets your asset allocation and timely rebalancing requirements with no fees or tax implications on such rebalancing.
As its name suggests, the fund invests in various equity, debt and gold mutual fund schemes of the mutual fund house ICICI and periodically rebalances based on its internal model. . Following the internal model ensures appropriate asset allocation at all times. The internal model is based on four main market indicators; PE ratio, price to book value, market capitalization to GDP and yield spread to G-sec. The model assigns equal weight to all of these components. This model gives a valuation index based on the input of these four ratios. This valuation index tells when is the right time to enter the market and when to exit and shift money into debt and gold from stocks. Thus, this model guarantees the right asset in the right proportion at the right time.
Due to the automation of the change and investment process, the undue influence of human biases is completely eliminated.
Due to the built-in diversification across various asset classes, its risk and volatility measured by standard deviation is lower than that of the Nifty Index. This model guarantees lower risk and volatility with equally good returns on equity over the long term. As the system is allowed to be 100% exposed in any asset class, the fund manager has the freedom to take the call of going overboard on a particular asset class at any given time in order to optimize returns for investors.
Tax aspect of asset allocation funds
Since the asset allocation fund of funds is a fund of funds and invests in many debt and equity programs, it is not considered an equity-oriented program and therefore you should keep your investment for 36 months or more to qualify for benefits. indexation and a 20% concessional flat rate available on long-term capital gains. With indexation, the effective tax rate is well below 20%. If you redeem your shares before 36 months, the profits are treated as your regular income and are taxed at your slab rate.
(The author is a tax and investment expert and can be contacted at [email protected])
Disclaimer: This is the personal opinion of the author. Readers are encouraged to consult their financial planner before making any investment.