Selecting which asset class to hold is a more important decision than which specific funds or securities to buy. Selecting specific funds purely on past performance may not help. As the saying goes, past performance is never a guarantee of future returns.

Some investors do spend time in creating the perfect asset allocation. However, it is important for your asset allocation to not be static, as things do change with time. Also, the complexity of stock market ups and downs requires a reworking of asset allocation according to changing conditions. Dynamic asset allocation helps an investor keep pace with the changing stock market conditions, protects against the downside and creates wealth for the long term.

Dynamic asset allocation

Strategic vs Tactical- While getting distracted with many investment opportunities may not give you the outcome you seek, you can aim to smartly exploit some short-term opportunities that come your way. People often interchangeably use the words ‘strategy’ and ‘tactics’, especially in the context of asset allocation. However, there are differences between the two. The two should work in tandem in order to achieve the desired result.

Strategy is a plan of action over a longer period. It is also defined as ‘long-range planning to ensure achievement of broad goals’. Tactics, on the other hand, are short-term in approach and work towards reaping benefits from the current scenarios. In short, it is all about predicting market opportunities. Predictions about markets may or may not always be right.

With prudent asset allocation, an investor never ends up in an adverse situation of having all investments in an asset class that performs poorly. Thus, delineation between strategic and tactical asset allocation would aid orderly investments.

Strategic asset allocation will involve periodically rebalancing an investor’s investment portfolio keeping in mind the long-term goals of the investment. It requires a certain percentage of assets in order to achieve a specific investment objective. It lies in the passive form of management and is aligned to the risk appetite of the investor.

Tactical asset allocation is a more active form of investing and is based on the idea of taking calls by anticipating stock market behaviour. For example, if an investor with a good risk appetite decides to take higher exposure to equity anticipating a bullish market, this is a tactical form of asset allocation. To benefit from tactical allocation, an investor has to keep track of the sentiment measures, such as index or benchmark movement for equity, and quarterly credit policy announcements for the debt market. Tactical allocation pertains to how much an investor varies from the strategic allocation by favouring one asset class over the other. While strategic and tactical asset allocation may differ in terms of time horizon and key drivers, they must be looked at as complementary components of a smart, integrated investment framework.

Implementing a dynamic strategy

Since an investor needs to be invested in the right asset class at the right time, the next question is how does one decide which asset class is right for what time. One may try and ‘time’ the stock market for the same, but, as mentioned earlier the investor will be vulnerable to various emotions. One way to go about this is to look at certain indicators which will help in feeling the ‘pulse’ of the stock market. There are various such metrics which may be considered. Using any of them will help in reducing the impact of emotions associated with investing as one would then make asset allocation decisions purely based on the examination of the relevant metric.

Specific metrics to use

Some of the more commonly known metrics are price-to-earnings (PE) and price-to-book (PB) ratios. PE is a valuation ratio of any company’s current share price compared to its per-share earnings (better known as earnings per share, or EPS). PB, on the other hand, compares a company stock’s value to its book value. Also known as the price-equity ratio, PB is calculated by dividing the closing price of a company’s stock by the latest quarter’s book value per share (estimated as total assets minus intangible assets and liabilities). In the context of market valuations, PE and PB both look at how cheap the equity markets are to decide upon asset allocation. However, looking at these metrics in isolation means that investors won’t be able to consider the valuation of debt markets in the process of deciding the appropriate asset allocation and, hence, they may not end up making optimum decisions.

Smart investors would ideally compare the relative valuation of both the equity and the debt markets and only then decide on the appropriate asset allocation depending on which of the two is better valued on a relative basis. One way to implement such a strategy is to understand the ‘yield gap’ ratio.

Yield gap

Considers both equity and debt valuations. Yield gap compares the earning potential of equity as against that from a long-term government bond. Consider the ratio between the yield on the 10-year government bond (an indicator for returns from debt markets) and the earnings yield of Nifty or Sensex (an indicator for returns on equity markets).

By comparing the returns from a government security, one can determine if the equity market is offering a better return at a certain time. As equity markets are riskier than debt markets, one should invest in them only if the expected return from them exceeds that from the debt market. Thus, this approach would recommend investing in equity only if one is compensated (with extra return) for taking additional risks.

olmdesk@outlookindia.com