The Role Of Asset Allocation In Investing

India’s large cap stock index has doubled in the past 4 years. The EPS (earnings per share) has also gone up in tandem. Supported by lower leverage and improved earnings growth, the mid and small cap indices have also rallied in “fast and furious” mode over the past 12 months.

In addition to earnings growth, the gush of continuous domestic liquidity, stable macros, political stability, government capex, better and improved performance of public sector companies, continuity of policies and reforms has led to a strong bull run in the Indian equity markets.

However after a 4 year dream run, some segments of the market have become over heated. It is pertinent to pay attention to the below quote on risk given the pace of the rally.

“Actual risk is highest when the perception of risk is lowest and vice versa”

As the markets reach new all-time highs, it is crucial for investors to reassess their current asset allocation. In most investment portfolio’s the percentage of equity allocation has gone up. This can be attributed to both return contribution as well as fresh inflows which tend to follow asset classes with the best returns. The markets tend to suck in all excess liquidity during good times.

The Role of Asset Allocation in Investing

Asset allocation is more than just a buzzword in the world of investing. It is a key strategy that determines the long-term performance of an investment portfolio. While market timing and fund/security selection are often highlighted as drivers of success, the reality is that asset allocation plays a far more crucial role in achieving financial goals and mitigating portfolio volatility.

Role of different asset classes in Investments:

When one looks at constructing a long term investment portfolio, each asset class—whether it’s equities, bonds, real estate, gold or cash—serves a specific purpose. The right mix of these assets creates a balanced portfolio that aligns with an investor’s goals and risk tolerance.

• Equities provide growth potential but with higher volatility
• Bonds offer stability and income, acting as a cushion during downturns but often are not able to beat inflation
• Real Estate diversifies and hedges against inflation to some extent but can go through long period of consolidation or stagnant returns and is relatively less liquid to other current assets. However over the longer term it has potential for appreciation and regular income in case of commercial real estate lease rentals etc.
• Gold acts as a decent hedge against inflation and especially in the past 2 years post the Ukraine war, gold has become one of the key asset classes. Not only have central banks globally bought gold but the prospects for the precious metal continue to remain good considering that the US fed is expected to start rate cuts from September. Gold and US dollar has an inverse relationship and with lower debt yields, gold becomes a potentially less volatile asset class as compared to equity
• Cash, money market/low duration and arbitrage funds are low-risk, liquid assets that protect against market swings and meet short-term needs

Minimizing downside risk

Asset allocation ensures that the portfolio beta is reduced and downside risk is minimised. By spreading investments across different asset classes, investors can reduce the adverse impact of a poor-performing asset. For example, when equity markets are down, bonds and gold can provide stability, ensuring that the entire portfolio doesn’t suffer a significant loss.

Capturing upside

Asset allocation not only helps in managing downside risk but also in capturing upside potential. The key is to maintain a disciplined approach, which includes adjusting the portfolio based on market conditions. This approach also called as dynamic rebalancing, allows investors to “buy low and sell high” by increasing exposure to undervalued assets and reducing exposure to overvalued ones. However, this strategy requires overcoming human emotions like greed and fear. Often, investors are tempted to chase high-performing assets or sell in a panic during downturns, which can lead to buying high and selling low—the opposite of what’s desired. A properly diversified portfolio can bolster an investor’s confidence to remain invested in equities during a bear market and provide a safety net in case of liquidity needs. This means that the investor doesn’t have to sell equities solely due to liquidity issues and can continue to stay invested until the market recovers.

Why allocation matters more than timing or security selection?

Many investors focus on market timing—waiting for corrections i.e. trying to buy at the lowest point and sell at the highest—or selecting the right funds/securities to outperform the market. While these factors can influence performance, research consistently shows that asset allocation is the most significant determinant of long-term investment success.

Predicting market movements consistently is nearly impossible, and even the best fund/security picks can falter if the overall allocation doesn’t align with an investor’s goals. On the other hand, a well-thought-out asset allocation strategy that considers the investor’s risk tolerance, investment horizon, and financial goals will ensure that the portfolio is resilient through different market cycles.

The simple solution

The essence of successful investing lies in “allocating across the right mix of asset classes, periodically re balancing within the asset classes based on their underlying valuations and staying invested for the long term. Although straightforward in theory, this approach is challenging due to market fluctuations and emotional biases.

Investors can take help from experienced and certified Mutual fund distributors who can recommend them towards the right asset allocation. They provide curated MF options tailored to an investor’s risk tolerance, and investment horizon. By leveraging their expertise, investors can make informed decisions about fund selection, ensuring that their investments align with their overall financial strategy. This guidance can be especially valuable for navigating the market volatility and identifying funds that offer the best potential for achieving long-term financial objective.

Disclaimer: The Views are Personal and not a part of the Outlook Money Editorial Feature