Dynamic asset allocation strategy to wealth simplified!

I am excited to present to you something interesting that I have developed. I have created a financial strategy which most households can adopt to create wealth while reducing risk.

Had one followed this, ?10 Lakh invested in 2004, would now be worth a staggering ?1.24 Crores. Note: The period analyzed includes the market crash of 2008, demonetization, mid & small cap crash of 2018. This strategy has been thoroughly backtested and has come out with amazing results.

Thank you all the readers for the feedback that you have given me on my previous articles. A few of you also requested me to simplify my articles which I intend to do in this article.

In this article I shall cover the following:

1. The Strategy explained
2. Backtesting results
3. Benefits of this strategy
4. Drawbacks
5. Who should adopt this strategy
6. Who should not adopt this strategy
7. The rationale for this strategy

The Strategy

In my previous article, I explained the 60:40 asset allocation strategy. In this article, I will explain a more dynamic version of asset allocation which everyone can implement without much external help. (Read: What is asset allocation?)

This dynamic strategy is based on Nifty P/E. This is a readily available ratio for market valuation which one can simply google. Simply put, P/E (Price to Earnings) ratio implies the amount an investor is willing to pay to earn one rupee as profit.

The allocation to Equities - Large Cap (Big Companies), Mid Cap (Medium sized companies), Small Cap (Relatively small sized companies) and Debt - Liquid/Arbitrage Funds is based on the Nifty PE.

Strategy Steps:

1. Allocate funds on the basis of this table
2. Review portfolio at the end of the year

Reading the Table:

Let's understand with an example. The Nifty P/E today is 29.69. So, the table implies that when the PE is above 26 (last row), one should invest 30% money in Large Caps and 70% money in Arbitrage/Liquid Funds.

What should one invest in?

One should invest in Mutual Funds of the following categories - Large Cap, Mid Cap, Small Cap, Arbitrage/Liquid Fund.

Should one invest in Arbitrage Funds or Liquid Funds?

While the returns from both these types of funds are similar, the taxation is different. Those who would be in the 20% income tax bracket and above ( Annual taxable income > ?5 Lakhs), should opt for arbitrage funds. Others may opt for liquid funds.

What type of Mutual Fund option should one select?

One must select the Growth option only. For those interested in fixed income, set up a systematic withdrawal plan.

How often should the portfolio be reviewed?

Ideally, review the portfolio at the end of each year from the date of investment. Based on the Nifty PE on that day, rebalance your portfolio according to the above table.

How to rebalance the portfolio?

Portfolio rebalancing is a simple process:

1. Calculate the total value of the portfolio by adding up all the investments.
2. Calculate the percentage of Large Cap, Mid Cap, Small Cap & Arbitrage/Liquid Fund to the total value of the portfolio.
3. Increase/decrease the percentage as required by buying/selling units of these funds.

Backtesting Results

I backtested this strategy starting from 1 April 2004 to 31 March 2019.

This chart brings out a surprising picture.

• Returns: While this strategy advocates investing in a mix of Large Cap, Mid Cap, Small Cap & Liquid/ Arbitrage Funds, the returns from this strategy are higher than all of them! We have always learned that averages are between higher and lower values. So how is this strategy delivering higher than its individual components? While one doesn't need to understand the working of electricity to use it, those curious to understand the reason can message/mail me.
• Risk: This strategy reduces the risk (volatility) of equities considerably.

Benefits of this Strategy

• This strategy delivers high returns while reducing risk
• Since the asset allocation is done objectively, human emotions are not allowed to play the spoilsport that they usually do (buying nears peaks during euphoria and selling at bottoms during panic times)
• Since the portfolio rebalancing is done after completion of a year, there are usually no exit loads (exit charges)
• Equity schemes and arbitrage schemes can claim the benefit of Long Term Capital Gains which are taxed at 10% of profits. One should sell only after completion of a year to get this benefit. Short term gains arise when Mutual Funds are sold before completion of a year and are taxed at 15%.

Drawbacks

• The above backtesting does not factor in long term capital gain tax (10% of profits) which has been made applicable of late. The expected future returns would be reduced to that extent.
• To simplify the strategy, the asset allocation is based on Nifty PE alone. This may not give an accurate picture of the valuations of Small Caps & Mid Caps.
• It seems high valuations are in trend

Who should adopt this Strategy

• Beginner investors
• Passive investors who are ready to review their portfolio once a year
• Those who do not have time to study and analyze the market
• Those who have a long term horizon (>5 years) for investing
• Those who do not want to take too much risk

Who should not adopt this Strategy

• Those who are ready to take high risk. There are asset classes which may deliver greater return with greater risk.
• Matured investors willing to invest directly themselves
• Those who haven't understood how to execute this strategy, and rebalance the portfolio

The rationale

While everyone doesn't need to understand this rationale, I write this to quench the thirst of curiosity that many might feel.

Observations & Inferences:

• Debt (liquid fund) is inversely correlated to equities. i.e. Debt delivers higher return when equities go down and vice versa. Combining the two opposites thus helps in reducing volatility
• Small Cap and Mid Cap Funds usually rise higher during growth phases when valuations are reasonable (low P/E) and fall steeply during the panic stage. Panic is caused by negative news. Such news many a time coincides with high market valuations (high P/E). Thus, a higher allocation is made to Small and Mid Caps when markets are reasonably valued and systematically reduced as markets start getting expensive. When markets become very expensive (Nifty P/E > 24) allocation to these is reduced to 0%.
• Large Caps are relatively stable amongst equities. They don't fall as steeply during market crashes. Thus, when the market is at high valuations, investments are made in Large Caps only as far as the equity portion is concerned.
• Arbitrage Funds offer debt like fixed returns while being beneficially taxed as equities. Thus for those liable to pay taxes at 20% or above, they are recommended over liquid funds.

I hope this broadens the knowledge horizon of my readers. The benefit lies, however, in implementing the same. Happy Investing!

If you are interested in reading more such articles you will find them here: https://www.finwisor.com/resources/research/fin-wisdom

Update:

I have received feedback, that this strategy may be difficult to execute given the time limitations that many have. There is an easier option for them.

We at Finwisor, provide NJ MARS (Mutual Fund Automated Rebalancing System) which makes this task easy for investors. It's available for FREE to all our clients. You may find more details about the same here: https://drive.google.com/drive/folders/1MI5tvMpdjcdiL1WtKAPayAQYQQNrxThV?usp=sharing

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