The original investment landscape consisted mainly of equities, bonds and cash as key asset classes. Over the years, commodities and real estate too got added to the list. Each asset class has its own share of highs and lows subject to macros and market condition.
- Equity markets, for example, tend to perform well over the long term. However, any significant domestic or global event can trigger volatility or even erode investors’ wealth in the interim. There have been such instances in the past – dotcom bubble, global financial crisis, COVID-19, etc. wherein there was wealth erosion
- Fixed Income markets are known to deliver consistent and stable returns to investors over the long term. However, global events like higher US treasury yields, high inflation, etc. may cause temporary volatility in the bond markets
- Gold acts as a hedge against inflation and like any other asset class, goes through various cycles. It can experience periods of stagnant returns such as between 2010 and 2020, as well as phases of strong performance. For instance, gold delivered ~16% returns post COVID, due to geo-political disturbances
Importance of Asset Allocation
Winners keep on changing across market cycles – equities perform well during expansionary phase, debt markets tend to perform well during contractionary phase and gold considered as a safe haven, performs mainly in times of economic stress. Investor sentiments and actions during market cycles are often reverse to that of market movement, i.e. they end up buying over valued assets during market euphoria and sell undervalued assets during downturn. Hence asset allocation, i.e. investing money across multiple asset classes, is of paramount importance. Since different asset classes tend to have low correlation amongst each other, this strategy is expected to deliver superior risk adjust returns over long term.
Key Principles of Asset Allocation
- Diversification – Diversification is an important part of asset allocation. Spreading investment across asset classes is the key to balancing overall market risk. However, an investor needs to be vigilant as over diversifying can lead to average returns experience
- Rebalancing – Asset allocation strategies require periodic rebalancing as market movements may affect the holdings of different assets in the portfolio. Failure to do so may lead to non-alignment with one’s financial goals
Should Asset Allocation be a part of Core or Satellite portfolio?
Asset allocation is often considered as an add on strategy when it comes to investment portfolio. However, it needs to be a part of an investor’s core portfolio to be able to generate alpha over long term. Just as an athlete requires a balanced meal to fuel his body and enhance overall health and performance, an investor too needs a balanced portfolio to achieve his goals. Higher exposure to any one particular asset class may not be beneficial across different market conditions. Hence, rather than a skewed portfolio it is better to have a diversified portfolio that can minimize market risks and generate returns. This can help investors weather market volatility and avoid making emotionally driven decisions during market downturns.
Asset Allocation via mutual funds
Implementing asset allocation strategies can be a challenging task for retail investors as one needs to have adequate knowledge about markets, taxation, timing etc. Hence, mutual funds offering asset allocation schemes is a good option for retail investors.
Besides diversification, other advantages that asset allocation schemes offer are – hassle free switch from one asset class to another, no tax implications on individual asset class level switch, fund manager knowledge and expertise across markets & asset classes and a disciplined approach to investing.
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