Allocating a Two-Asset Portfolio

Asset allocation and diversification are considered to be the holy grail of investing. Adding non-correlated assets to one’s portfolio is supposed to reduce volatility and hence encourage the good behavior of staying invested through market cycles. Here, we look at a simple two asset portfolio and work through some simple scenarios.

Picking the Assets and Allocation

When one looks historical inflation adjusted returns (link,) an investor with a 10+ year horizon should be invested in midcaps. So we pick the NIFTY MIDCAP 100 index and the 0-5 year bond total return index as the assets for our simple allocation setup.

The most popular allocation for an equity/bond portfolio in literature is 60/40 in favor of equities. However, we will go through a range of scenarios where the equity allocation is stepped through from 40% to 90% in increments of 10%

After picking the assets and their allocation, we need to figure out what would trigger a rebalance. Should we rebalance whenever the weights go off by 5% or should we wait until they drift 20% from their initial allocation? We will step through this as well – from 5% to 100% in increments of 10%

And lastly, the question of capital gains and securities transaction tax. Tax incidence on these two asset classes have varied over time. So for simplicity, we will assume an STT of 0.1% and a capital gains tax of 10% applied whenever a rebalance occurs.

The results

As one would expect, higher the risk taken, higher the cumulative returns. What changes are the drawdowns. Here are the various allocations, assuming a 20% rebalance threshold and with/without the tax drag. Note the different drawdown profiles at the bottom of the chart.
Without taxes:
equity/bond with 5% rebalance threshold (no tax drag)
After tax:
equity/bond with 5% rebalance threshold (no tax drag)

And here are the historical returns of the 60/40 portfolio:

pre and post tax returns of a 60/40 equity/bond portfolio
As intuition would suggest, the more frequently you rebalance, the higher your tax incidence. But keeping the rebalance threshold too high would allow a single asset to balloon and make the portfolio too sensitive to it. As show in this table, historically, keeping a rebalance threshold at 20% has worked out well for a 60/40 equity/bond portfolio.

Code, charts and the complete result dataset are available on github.

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