Mutual Funds Day 4: Asset Allocation — DIY vs Professional
In the last chapter, we learned about the Assets that are available for Investment. In the current chapter, we will learn the precedence of which Asset Class to choose. You can think of this chapter as the practical class for the theory learned earlier.
“Everybody has some information. The function of the markets is to aggregate that information, evaluate it, and get it incorporated into prices”. — Merton Miller
“The enemy of a good asset allocation is the quest for a perfect one. Fight the urge to be perfect.” ― Richard A. Ferri
The process by which the Fund Advisor decides what percentage of the money goes to Equity, Debt, and Gold is called Asset Allocation. If we take the example of two people A & B, both are 40 years old, working in the same company, married with 2 kids, and drawing the same salary — yet the asset allocation need not be the same.
The reason is that the dreams and goals of A will never be the same as B even though they have similar incomes.
Asset allocation also has to do with risk appetite (which we will cover in a separate chapter), but it is mainly related to your financial goals. In the US an ideal retirement portfolio had 60% equity and 40% debt. These days, the allocation percentage to equity is kept at a higher value to generate higher returns. Most of the new-generation investors prefer to go with 100% equity. What is the right mix, only time will tell.
Do it Yourselves (DIY) vs Choosing a Financial Advisor
People prefer to perform the asset allocation manually and not rely on an external financial advisor. With the advent of technology and commission-free mobile apps, there is a huge advantage if you hand-pick the mutual funds. You can save up to Rs50 per Rs10000 if you invest directly and skip a financial advisor.
The main disadvantage of a DIY model is “Time”. You need to actively manage your funds and do the switching perfectly to match your financial goals. If you have the time & knowledge for the same, it is better to save the Rs50/Rs10000 commissions.
Secondly, most DIY’s select the mutual funds with the highest historical returns and ignore performing research. A fund that was top-ranked in a particular year may or may not perform 5 to 10 years from now.
Thirdly, the DIYs do not prioritize splitting their investments into different asset classes. Most of them are 100% equity. We cannot blame them, equity has outperformed every other asset class in India, especially in the last 4 to 5 years. For example, Nifty50 gave annual returns of 32% in FY2023–24 — this news itself will attract a lot of fresh blood into equity.
A Certified Financial Advisor on the other hand will audit your current allocation and then suggest course corrections. They have access to a broad range of tools & calculators. These days Artificial Intelligence (AI) based fund finders are available provided we give the inputs correctly.
The results may not be visible immediately, but reviewing your funds with the FA 4 to 5 times a year will outperform DIYs in the long run. The reason is, that FAs will help you allocate more to equity if the valuations are better and route more to debt if the markets are over-heated.
Static Vs Dynamic Asset Allocation
In Static Asset Allocation, you decide what is the goal, find the mutual fund according to that, and then SIP it. As long as the goal of the mutual fund is matching your requirements, no change is required. If your tenure is 5 years, you can continue investments for the entire 60 months and then redeem the funds to meet your financial targets.
Most often investors prefer to continue with the same mutual funds throughout the tenure. The research is done before the purchase and once decided they adopt a fill-and-forget strategy. The biggest advantage is that you save “Time” as no future adjustments are done.
Dynamic Asset Allocation on the other hand requires frequent review of the portfolio and make adjustments throughout the journey. It is like taking feedback and then improving the process. The biggest advantage is that your financial goals will be met accurately and as per schedule as minor course corrections can be beneficial. The biggest disadvantage is that you spend more time as the research is a never-ending process.
For example, you start with a portfolio of 65% Equity, 20% Gold and 15% Debt. After 6 months if the stock markets crash and the valuations become attractive, you could change the allocation to 80% Equity, 10% Gold, and 10% Debt.
An important aspect of Dynamic Asset Allocation is that we need not sell holdings and churn investments. Selling always comes with Taxes and Charges that will drag your total ROI. A better way to handle this is by pausing the current SIPs and routing the funds to a new asset class. Your monthly contributions remain the same, it is just that you are buying more equity than gold with the same funds.
If a particular AMC or mutual fund has a red flag, compliance issue, or any other bad actors then it makes sense to exit the same and allocate the funds to a different fund/AMC. Sometimes selling at a loss is much better than losing the entire capital. There is a tax exemption of Rs1,00,000 per year for Long Term Capital Gains (LTCG). In the worst case an exit is required, you could even utilize this clause and save taxes.
DIY investors usually go with “Static Allocation” whereas investors signed up with a Financial Advisor prefer “Dynamic Allocation”. In good times the difference between the approaches is hardly felt, but in bad times Dynamic Allocation strategies will outperform by a huge margin.
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