The asset allocation process would require a disciplined structure based on three assumptions. The securities market indicates the rate of returns available in the various asset classes. There is a normal relationship among these implied returns. The securities market correct disequilibrium conditions when they occur.
1. The securities market indicates the rate of returns available in the various asset classes. The investor knows the yield on cash. He knows the yield to maturity on long term bonds. And he knows the P/E ratios of stocks in the equity market (which give him an idea on the long-term returns available in the stock market).
2. There is a normal relationship among these implied returns.
3. The securities market correct disequilibrium conditions when they occur. For instance, if the equity market strays away from their normal relationship with fixed income securities. Then the forces of the securities market (through a money flow from fixed income securities to the equity market) will pull them back in line; i.e. back to their normal relationship.
It is important to note at this point:
Firstly, opportunities lie in markets, which have swayed from their normal relationships or their equilibrium.
Secondly, opportunities also lie in the economic conditions, which can sustain a return to equilibrium. This tendency of the markets to return to their equilibrium is the profit mechanism of any asset allocation strategy. Further, it is also important to assess the market sentiment, with respect to whether the market would move now or later.
So, tactical asset allocation processes; firstly, share a disciplined structure, secondly are contrarian in nature and thirdly enhance portfolio performance substantially.
Let's say we have a portfolio value of INR 1,00,000.00, which can give us a return of 10% per annum over the next 10 years. Here our initial value would become INR 2,59,000.00 by the end of the 10 year period.
Next, let's say we apply a simple rebalancing technique. This would require us to rebalance the parts of the portfolio back to their normal levels every month. If stocks go down, we buy more to bring it back to its normal value level. If bonds go up, we sell a part of our bond exposure to bring it back to its normal level. Historically, this passive strategy has added 30 basis points per annum to returns over the long term. So, our return in this situation would be 10.3% per annum over a period of 10 years. By which our initial investment would become INR 2,67,000.00 at the end of 10 years. Thereby adding INR 8,000.00 to our return.
Further, let's say we introduce a 20% active asset allocation range. This would add an additional 1% per annum to our annual return; i.e. a return of 11.3%. In this situation our initial investment would become INR 2,92,000.00 at the end of 10 years. This would be an additional return of INR 25,000.00 at the end of 10 years.
Here, I would like to caution you that the implementation of this process would have to be disciplined, without which we would be headed for losses and disaster.