ASSET ALLOCATION

Anil’s expectation for return on his investment last year, was at least 35%p.a. A booming stock market had led him to believe that such a large rate of return was indeed achievable. Today, after the markets have corrected nearly 60%, Anil is not sure. He thinks that even an 8% return, as long as it is secure, should be fine. Anil was willing to take risks with his investments last year, but is unwilling to stake any of his capital, this year. The drastic changes in Anil’s preferences can hurt the performance of his investments. How?

If Anil’s investment choices are led by the immediate past performance of his investments, he may end up with wrong market timing. He would be most tempted to buy into equity, when markets move up, and withdraw when the markets are down. This effectively means, he would buy at the top of the market and sell at the bottom of the market, and therefore make no effective long term return. Investors always tend to be swayed by the immediate past performance of their investments, which could harm their portfolios.

There is no single category of investments that would perform well, across time. Equity, debt, commodities, real estate, gold and all investment categories are subject to cycles. For example, in an inflationary environment, commodities may do well, but stocks may not. In an expansionary phase, equity may do well, but debt may not. In reality, the performance of various investment choices varies with time. Anil’s best bet therefore would be a sensible asset allocation, an old and wise strategy to investing.

If Anil had even 20-30% of his money in lower return yielding debt instruments, even as the equity market was booming, he not only would have enjoyed some insulation from the crash, but also would have seen handsome returns on the debt portfolio, even as equity was correcting. If Anil continues to buy into equity, in the fallen markets, he might see a higher return on his portfolio when the equity cycle picks up.

To be able to practice asset allocation, Anil will have to come to terms with the fact that some components of his portfolio will earn a lower return than the best performing component. To hold some money in low-return yielding debt instruments, when equity returns were higher, is a conscious decision to take, with an eye on risk. The same is now true for debt. Anil needs to hold low-yielding equity, along with high-yielding debt, so that he is well positioned to make gains when the equity market moves up in future. Asset allocation is the only sensible way to manage risks in a portfolio, and too much of concentration in any single category can be harmful to any portfolio.

A period of prolonged gains, as happened to Anil in the equity bull-run, can lead us to believe that market direction is predictable. Crashes like the one we now see tell us that markets inherently are unpredictable. Sensible asset allocation is a valuable guard against the misconception of steady and predictable returns from any single investment category