With returns driving most financial investment decisions, chasing the latest fad is a costly mistake many commit. Going after one year’s top performing asset class can easily become next year’s laggard for your portfolio. Without a proper asset allocation approach, the nuanced art of going for consistent compounding is never learnt; instead high-risk, high-return bets become the norm and this leads to disappointments and a rocky investment journey. The truth is a diversified portfolio across multiple asset classes, over long time, tend to deliver consistent result thereby helping one meet every financial obligation in time and in a stress free manner.
A game of snakes and ladders
Equity as an asset class tends to outperform every other asset class over long term. But this journey is fraught with volatility. However, the winners in terms of asset classes keep rotating every year. This is because each asset class has a market cycle of its own. For example, equity markets tend to perform well during expansionary phase but debt markets tend to perform well during contractionary phase. Proper and timely shift of allocation between asset classes can help ensure a smoother investment journey. There will be ups and downs, and these will be pronounced when there is high allocation to the wrong asset. Instead of an investment ride that is replete with fits and starts, asset allocation takes calculated bets in a nuanced manner and thus shield your portfolio from sharp moves.
Allocation towards the right asset class is a key determinant for portfolio performance over a long run. Studies show that consistent asset allocation, an overlooked area, has 91.50 per cent weight in long-term portfolio performance. Security selection, an area where investors tend to focus a lot, accounts for 4.60 per cent weight. Recall the amount of time and energy investors allocate to identifying high risk-, high-return investment opportunities! Not surprisingly, market timing accounts for less than 2 per cent in determining portfolio performance.
Hedge against Erratic Behaviour
The various reactions of an investor range from optimism to despondency across a market cycle. When the market rallies, instead of being cautious, investors tend to go overboard on equities and vice versa. “Be fearful when others are greedy and be greedy when others are fearful” goes the saying by investing legend Warren Buffet, but more often investors do the exact reverse. When equity markets are richly valued, historical data shows that inflows into equity markets witness a spike and when valuation becomes cheap post a correction, there is significant outflows. Hence, investors at large tend to get caught up in asset bubbles and face sub-optimal portfolio performance. What is the solution to this? Simple answer: Allocating to various asset classes.
Helping investors achieve this objective are various asset allocation schemes. The 10-year category average return of multi asset allocation funds is 9 per cent CAGR and that of dynamic asset allocation fund is 10 per cent CAGR. Consistent asset allocation enhances the power of compounding. With such a time-tested approach, you will not need the adrenaline rush or the lure of high risk-high returns. With asset allocation, rebalancing happens at regular intervals and the deviations are corrected on an auto-pilot, thus minimising the risks that may have crept into the portfolio. Similarly, a healthy mix of assets ensures that you are exposed to equity, debt and other assets based on their individual merit at that point in time. So, such asset allocation automatically cuts allocation to sub-optimal asset classes while upping exposure to the asset class that promises the best outcomes at present.
To conclude, in any market condition, asset allocation is important for attaining optimal portfolio returns and reaching financial goals based on an individual’s risk appetite. Like a true friend who protects you, asset allocation acts as a counterbalance and shields your investment portfolio from common mistakes. Apart from this be consistent with one’s investment and allow the magic of compounding to play out in your portfolio over the long run. While at the start of investing, you may not see significant gains coming in, but after say 5-6 years and a complete market cycle, the gains clocked in will be sizeable in nature.
Data Source: Value Research
Laherchand Gogri, Managing Director, Pure White Investments Private Limited
The views are personal and are not part of the Outlook Money editorial Feature.