With fears of double dipped recession in US looming large and Euro-zone crisis dragging on, investors would want to rush towards cash and safe haven assets. But, what can be termed as really “safe” in these times? As economic conditions remain fragile, the equity markets around the globe have corrected drastically in last few days on account of poor investor sentiment. In this article, we aim to check whether the traditional investment philosophy of asset allocation can work well for retail investors.
“Don’t put all your eggs in the same basket” is the basic rule of diversification. By choosing to invest in multiple assets, we cut down on the volatility experienced by one asset with another. At times, one may come across an investment proposition that seems like a “good bet”, but its potential volatility may skew the risk profile of your portfolio. In such situations, a Core and Supplementary Portfolio structure allows you to manage risks better.
A core portfolio comprises diversified assets that are essential to meet your primary financial needs and risk profile. About 80-85% of your investible surplus should go into this core portfolio. The remaining, 15-20% can go into the supplementary portfolio, which could be a more concentrated, higher risk asset for the additional kicker.
Before investing, one should be clear about the final investment objective – whether it is need based, or purely to accumulate wealth. With a long-term horizon and objective to create wealth, one can take more risks but, if you wish to preserve your savings, then one should have income generating products in core portfolio.
So, a young person with no dependency can have equity funds in the core portfolio whereas, an individual who is approaching retirement should invest surplus cash into the same fund. The percent or weight allocated to each product thus, should vary according to your age, risk appetite and time horizon.
Favourable in Good, Bad and Ugly Times
As an illustration, we compared the annual returns of BSE 30 and Gold since 1980. The average yield of 10 year government security between 2000 and 2010 represents fixed income return. The charts show the returns for time periods, when the market conditions have been the most and least favourable.
We can see that the allocation to muliple asset classes in a portfolio has limited losses arising out of one asset class. So, while equities corrected sharply in 2007, Gold and fixed income have delivered positive returns; whereas in 1984, the BSE Sensex gave a whopping return but, Gold returns were in negative. However, the total returns from an investor’s portfolio would also depend on share of each asset class in the portfolio. For example, a highly concentrated debt portfolio may not suffer major loss during market downturn but, conversely, would not see a major upside in a bull market.
source: iFAST Compilations
source: iFAST Compilations
Let’s say, a portfolio is invested with Fixed Income at 50%, Indian Equity (BSE 30) at 35%, Gold at 10% and Global Equity (MSCI Index) at 5%. The standard deviation or a term used to understand the variability in returns for combined portfolio is at 12.77%, much lower than single exposure to Gold (14.65%), MSCI Index (18.36%) and BSE Sensex (35.46%) over a span of 30 years. Thus, a well-diversified portfolio can reduce downside risk for an investor.
Investors across the world can be easily separated according to their propensity to accept risk. One set of retail investors mostly opt for guaranteed income, capital protection products whereas, the other, aggressive type prefers to place bets on higher return products. But, to beat the rising inflation as well as overcome the volatile markets, the twain should meet!
A combination of investment products across asset classes, product types and geographies in the portfolio can reduce volatility, maintain cash flows as well as beat inflation in the long run. That’s why asset allocation seems pertinent in today’s times.