Understanding Dynamic Asset Allocation

With changing dynamics in the economy, new investment strategies keep emerging every passing day. Developments in one part of the world impact the equity and debt markets in another part of the world. The resultant impact at times also spills over to physical assets like real estate and gold. These changes often result in expert commentary either in favor or against particular asset classes or strategies.

However, in all situations, most financial pundits remain unanimous on certain basics. Consistency in investing and asset allocation are among such fundamental pillars of investing, that have resulted in tremendous financial success to ordinary but determined investors.

Consistency in investing is self-explanatory. Let us understand Asset Allocation, its traditional form and a slightly modified version.

What is Asset Allocation?

In its simplest form, asset allocation is spreading out your investments to different asset classes. Traditional wisdom encapsulated this philosophy as not putting all eggs in the same basket. In the world of investing, this translates to not investing your entire corpus or all of your savings in a single investment instrument or asset. For example: You should not invest all your money just in equities, or bonds, or real estate, or gold. Instead, some part of your money should go to all these asset classes.

The proportion in which you allocate your money to each of these asset classes is your asset allocation strategy. If you invest 50% of your funds in equity and the rest in fixed income instruments, you have an equity, debt asset allocation of 50% each. The idea is that if one asset class performs poorly, the other asset classes could perform better. For instance, the broader Indian equity markets (Nifty 50, BSE Sensex) have largely remained flat over the last one year. However, at the same time, yields on debt instruments like bonds, and debt mutual funds, have gone up with the interest rates in the economy going up.

The logical question that follows is what is the ideal asset allocation? The simple answer is there is no one-size-fits-all approach in personal finance and consequently asset allocation. But the general principle to be followed is taking a higher degree of risk when one is relatively young, have fewer responsibilities, or have a long runway in your career. So, someone just starting a career can have a majority of their investments in equities, which is a risky and volatile asset class. On the contrary, someone approaching retirement should ideally allocate more to relatively safer options like fixed income instruments or debt mutual funds.

Despite the risk, in the long run, equities have delivered superior returns compared to other asset classes. But the idea behind reducing equity investments closer to financial goals is that that money needs to be safe, available for use and not lost in market volatility.

While all of this seems easy, implementing this tends to be very challenging for most of the investors. This is a where dynamic asset allocation fund comes in handy.

What is Dynamic Asset Allocation?

In a dynamic asset allocation, the fund manager allocates asset to multiple asset classes basis the various opportunities available. The asset classes covered in this category are equity and debt. The approach here is largely being counter cyclical. This means that when the equity markets tend to be expensive, the allocation towards debt is increased and vice versa. This ensures that the fund manager stays away from overvalued asset class. So, even in the event of a market correction, the investments are not materially impacted owing to the reduced equity exposure. What the mechanism effectively achieves is buy low and sell high.

By investing in this category investors do not have to worry about rebalancing the allocation between equity and debt from time-to-time. Also, an allocation to such a fund helps overcome behavioral challenges that an investor may face. When the equity markets are heading higher, it is very difficult for an investor to book profits as the investor may worry on missing out on the further part of the rally. Furthermore, when such rebalancing is done on an individual basis, the investor is bound to attract short or long term capital gains tax. But when the same is done on a fund level, the investor does not attract any taxes.

To conclude, if you are an investor looking to allocate to equity and debt, then dynamic asset allocation category is a worthy consideration.

The views are personal and are not part of the Outlook Money editorial Feature

Suresh Kumar Kakani, Director,Fortune finsec Pvt LTD