Friday, May 27 2022

As investors, our job is not to predict the future but to keep the portfolio well positioned. Events like COVID or the current geopolitical crisis, along with other variables, cause markets to rally & fall. A well-positioned portfolio is resistant to such volatility.

A portfolio achieves the goal of being well positioned by applying asset allocation and rebalancing. The underlying principle of asset allocation is that different asset classes offer varying returns depending on their correlation. Thus, a portfolio diversified across several asset classes, which are weakly correlated, will offer better risk-adjusted returns. According to a research paper, 91.5% of the portfolio performance of major US pension funds was attributed to asset allocation.

Asset allocation is relevant for an investor because risk tolerance, liquidity needs and investment objective are the essential criteria to finalize the asset allocation. We divide asset allocation into strategic and tactical asset allocation. The strategic asset allocation is based on the risk profile and is the long-term allocation. In contrast, tactical asset allocation helps reposition the portfolio based on events and the macro environment.

Rebalancing and asset allocation

What is portfolio rebalancing?

Portfolio rebalancing is an exercise to bring asset allocation back into a predefined range by exiting or booking profits. Significant rebalancing should be a mid-term exercise, not quarterly. The portfolio can have a mix of active and passive investments, but the asset allocation must be actively maintained.

When should you consider rebalancing?

The first reason to rebalance is to return to the strategic asset allocation range.

Asset allocation is based on an investor’s risk profile, so whenever the distribution of a specific asset class increases or decreases, rebalancing is necessary.

We also recommend having a cash allocation in the portfolio. These are low risk, low return investments. A 10-20% cash split is ideal. This cash can be used urgently and tactically when the market offers short-term opportunities.

To ensure that the asset classes in the portfolio are low correlated, such as within equities, they should be split between India and the world due to their very low correlation.

Apart from low correlation, other aspects such as rolling returns, their variance, downside during market fall and recovery period are other key factors in asset allocation. This also justifies the addition of new asset classes such as venture capital funds, litigation funding & amp; digital assets to the wallet.

Finally, the performance of each investment in a particular asset class should be reviewed with attribution analysis. If a particular investment does not outperform the benchmark for an extended period of time, it should be dropped and the better performers should receive more money.


The goal of diversification is to generate better risk-adjusted returns with lower volatility in the portfolio. Having many investments in the same asset class is neither diversification nor asset allocation. For example – if the portfolio has a 100% equity allocation but has multiple PMSs, AIFs and mutual funds, this is not diversification as there is a high chance of a portfolio overlapping. Rebalancing after a portfolio overlap analysis solves this pervasive problem.

A common reason why many investors choose to have multiple plans in the portfolio is under the misguided notion of risk management. Even within various market capitalization indices, there is a strong correlation. It cannot therefore be considered as diversification.

From December 31, 2004 to December 31, 2021. The indices are Sensex PRI, BSE Mid Cap PRI and BSE small cap PRI.

The risk of over-diversification is that the portfolio obtains returns similar to those of the benchmark index, but with:

1. Disproportionate risk; and
2. Higher Monitoring Fees and Costs

Portfolio diversification should also take into account the profile and background of the investor. If you own a pharmaceutical business, your investment portfolio would be better off with minimal or no exposure to the pharmaceutical industry.

Tactical allocation

The objective of pursuing tactical allocation is to amplify portfolio returns and reduce volatility. Up to 15% of the portfolio depending on investors’ risk appetite may be retained for tactical allocation. The portfolio’s cash allocation can be used for these tactical investment decisions.

Tactical allocation can also be done for a short-term trade: buyout arbitrage opportunity with low downside and high certainty of moderate upside.

Tactical allocation also helps the portfolio rebalance itself based on the macro pattern and global events.

1. Make changes based on geopolitical events. Example of increased exposure to energy commodities during the current crisis.

2. What asset classes to invest in when inflation changes – increase exposure to commodities or companies involved in commodity trading when inflation rises.

3. Reduce exposure to long-term bonds or increase allocation to floating rate bonds when interest rates are likely to rise.

In conclusion, any savvy investor would do well for their portfolio by following the 3-step process of monitoring, rebalancing & reviewing it at regular intervals. The key thing to remember is to stick to asset allocation and rebalance to keep both risk & returns in check in the portfolio.



The opinions expressed above are those of the author.



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