Asset allocation: based on financial goals or market valuations?

I am a DIY investor and have been investing for the last few years. I understand asset allocation, so I divided my portfolio between equity and debt in a 60:40 ratio. Because of good equity markets, my asset allocation is skewed towards equity, with a 75:25 allocation. 

Now my doubt is if asset allocation has to be done based on my future goals or on market valuations. When the market is overvalued, experts recommend going underweight on equity and increasing debt allocation. What is the right approach? 

It is not without reason that asset allocation is considered the cornerstone of one’s investment journey. If you are an investor who designed your portfolio to minimize portfolio volatility, it is important to stick to your asset allocation by rebalancing it. If you are risk-averse and frequent market swings with higher equity exposure disturb your sleep, there is no point in earning higher returns at the cost of your peace of mind.

Having said that, if asset allocation is tied to future financial goals, it is best not to tinker with your portfolio frequently. Long-term objectives typically warrant higher equity exposure, while short-term goals are better served by debt instruments. While market valuations may fluctuate, retail investors should resist the urge to rebalance their portfolios constantly in this case. 

Given India’s high inflation rate and limited investment options that can consistently beat inflation, maintaining long-term equity exposure is crucial. Frequent portfolio rebalancing can hinder the power of compounding, which is essential for overcoming inflation.

But when the financial goals are approaching, it’s important to rebalance and completely reallocate from equity to fixed-income investments. One needs to start looking at rebalancing within 4 to 6 years of the goal maturity. Such a large buffer is suggested as markets move in cycles. Case in point: If an individual’s financial goal was in March 2020 and if the investments were stuck in the equity portfolio until then, the individual would have had to compromise on the goal value because of the dip in the equity markets due to COVID-19 news. 

Hence, before the financial goal arrives, one must start gradually withdrawing from equity portfolios and invest in conservative fixed-income products such as fixed deposits, debt funds, etc., for the remaining period of the goal maturity. Tools like STP (systematic transfer plan) are available in mutual funds that systematically transfer money from equity to debt funds over a period ascertained by the investor.

Hence, the best way to create long-term wealth is to stay invested in equity if it is meant for long-term goals. Having said that, it’s also important to manage risk in equity positions. After all, balance is a key to success in investing, as it is in life.

If you are worried that the market is significantly overvalued, you can consider shifting allocations from small-cap and mid-cap funds to flexi-funds. In flexi-cap funds, fund managers generally adjust exposure based on market conditions. 

This column is just to give a financial planner’s perspective, which is subjective. The views and opinions expressed in this blog are those of the author. All content provided is for informational purposes only and should not be taken as professional advice.