A basic primer on asset allocation

By Morningstar |  28-09-20 | 
 

Rishiraj Maheshwari, founder of RISCH Wealth and Family Office, in a conversation with Dhaval Kapadia, Director – Portfolio Specialist, Morningstar Investment Advisers India, discusses the main drivers of return in a portfolio.

Rishi: What is asset allocation?

Dhaval: In simple terms, the phrase ‘don’t put all your eggs in one basket’ gives a good sense of asset allocation. It is about investing in different asset classes like domestic equity, debt funds, real estate, gold, cash and international equities. Each asset class has different risk and return characteristics and asset allocation is about deciding the right mix and weight of each asset class in a portfolio.

Many retail investors think mutual fund is an asset class. Is mutual fund an asset class?

Mutual fund is a vehicle to invest in different asset classes. One can achieve diversification by investing in different types of funds like debt funds, liquid funds, equity funds, gold ETFs, and international fund of funds. One asset class can’t be compared with the other. Each of these asset classes have a role to play in the portfolio and have a different risk-return trade off.

Why is it necessary to invest in different asset classes?

Let me take the analogy of health. Today, it has become extremely important for us to maintain our health. It is not just about exercising and eating right. Good health is a result of a combination of factors. It is about eating the right quantity and type of food, exercising adequately (not too much or too little), having mental peace, and taking adequate rest. A balance of all these factors contribute to good health.  Similarly, you need different asset classes to have a balanced portfolio.

People spend too much time in selecting the right fund/stock and try to time the market. But research has shown that the primary decision of how much to invest in equity, debt and other asset classes is the main driver of the performance of a portfolio, over the long term. Let me cite an example. If someone was holding a 100% equity portfolio during the 2008 global financial crisis, that portfolio would have dropped by 55-60% by the end of 2008. On the other hand, if someone was holding a mix of debt (50) and equity (50%), the portfolio would also have fallen but much lesser than the 100% equity portfolio since debt acted as a cushion and protected the downside.

How does one decide the asset allocation?

Investment horizon and risk appetite are two major factors for zeroing in on the ideal asset allocation.

Asset classes such as equity tend to exhibit high volatility in the short run. For instance, markets corrected sharply in March-April 2020 and recovered subsequently. In the short run, there are chances of making negative returns as well. As your investment horizon increases, chances of making negative returns diminish. Let me share with you a study done by us internally. We analysed the calendar year returns (1980 to 2019) and found that market has yielded negative return 10 times out of the 40-year time period. As you increase your time horizon by five years, this proportion of making losses comes down significantly. On multiple five-year periods, if you take the overlapping 5-year periods over the last 40 years, there are about 36 odd periods. Out of this, there were only three periods, which have generated negative returns. If you increase the horizon to 10 years, there are no 10-year periods when equities have generated negative returns. So equity is meant for a longer time horizon. How much to invest in debt and equity depends on your risk appetite and time horizon. The equity allocation should be less for an investment horizon of up to five years.

How must retail investors stick to their asset allocation?

If your horizon is five to seven years and you have a moderate risk appetite, your asset allocation could be around 50% (equity) and 50% (debt). If markets were to correct sharply, say by 30%, your equity allocation automatically comes down due to the fall in market. Post a 30% fall in the market, the 50% original allocation to equity would have fallen to say 35%. Rather than focusing on market noise/news which tends to be short term in nature, investors could simply increase their equity allocation back to 50%, assuming long term fundamentals of that asset class are intact. Similarly, if markets shoot up by 20-30%, your equity allocation would automatically increase. In such cases, you can reduce your allocation back to 50%. To sum up, asset allocation ratio should be used as an anchor to make investment decisions.

Let me cite an illustration. Follow a basic principle of buy low and sell high. From 2014-2017, the markets did very well. Those who had invested in small and mid caps saw their portfolio grow 2.5 to 3 times. So if you had invested Rs 100, it would have grown to Rs 250 – Rs 300 in three to four years. Instead of withdrawing money, people kept investing more into small and mid caps in 2017-18. Subsequently, we saw a 50-60% correction up to April 2020. If you had cut down your exposure in small and mid cap after the sharp run up to your pre-decided/target allocation you would have protected your portfolio from this drawdown.

Sticking to target asset allocation keeps your focus on your goals.

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