Asset Allocation: The Cornerstone of Successful Investing

February 20, 2024 Mutual Fund

In the ever-evolving world of finance, navigating the complexities of the investment landscape can be daunting for both seasoned and novice investors alike. While the allure of high returns beckons, the inherent risks associated with financial markets pose a constant challenge.

The global economy in 2024 is shrouded in significant uncertainty, with experts offering a range of forecasts and potential scenarios. While a global recession is not widely predicted, growth is expected to be subpar compared to historical trends.

Currently, the global economy is navigating a delicate path, trying to tame inflation without sacrificing growth. Ongoing conflicts and rising tensions between major powers can disrupt trade, investment, and energy supplies, further destabilising the global economy. Persistently high inflation remains a major concern, eroding purchasing power; however, experts have anticipated it to ease gradually.

[Read: The Indian Equity Market: A Symphony of Economic Melodies]

Additionally, extreme weather events and the ongoing need for climate mitigation and adaptation can disrupt economic activity and pose long-term risks.

While the global economy may face a potential slowdown in 2024, India’s economic outlook appears relatively positive compared to many other countries. However, the actual performance of the Indian economy will depend on how effectively it navigates these challenges and capitalises on its potential growth drivers.

The Indian economy has historically demonstrated resilience and continues to be one of the strongest among the world’s major economies. Investors should not be complacent, as India cannot be completely decoupled from a global slowdown.

As a result, investors should be ready for volatility and possible market corrections in the interim. Refrain from unreasonably skewing a large portion of your portfolio to equities based only on past performance or the achievements of other stock investors. This is the point at which asset allocation becomes relevant.

[Read: What Should Be Your Mutual Fund Asset Allocation Strategy Amid Rising Global Uncertainty]

Navigating the current uncertain economic environment requires a strategic and adaptable approach to investing. Prudent asset allocation emerges as a crucial tool in this scenario.

This article delves deep into the concept of asset allocation, exploring its significance, strategies, and practical implementation. We’ll embark on a journey to understand how strategically dividing your investments across different asset classes can pave the way for long-term financial success.

Understanding Asset Allocation: The Balancing Act

Imagine yourself walking a tightrope. On one end lies the potential for high returns, but with it comes the risk of significant losses. On the other side lies stability and lower risk, but potentially lower returns. Asset allocation is like finding your balance point on this tightrope, strategically distributing your investments across different asset classes to achieve your desired risk-return profile.

Asset Classes: The Building Blocks of a Portfolio

You can choose from different categories of investments known as asset classes. Each asset class has its own unique characteristics, risk profile, and historical performance. Some of the major asset classes include:

• Equities (Stocks):  They represent ownership in companies and offer the potential for high capital appreciation over the long term but also carry higher risk due to market volatility.
• Fixed Income (Bonds):  Represent loans made to governments or corporations, offering regular income payments and capital preservation, but generally with lower potential returns compared to equities.
• Gold (Commodity): Gold has historically been considered a valuable asset class and a safe haven, particularly during times of economic uncertainty. As an asset class, it represents indirectly gaining exposure to the price of gold through the holdings of the specific gold mutual fund you choose.
• Cash and Cash Equivalents: Liquidity plays a crucial role in effective asset allocation, enabling you to manage your portfolio strategically and achieve your financial goals. Cash and cash equivalents are generally considered low-risk investments, helping to stabilise your portfolio and mitigate the impact of market fluctuations.

Different types of mutual funds invest in different asset classes, such as stocks, bonds, commodities, etc., depending on their investment mandate. Accordingly, every mutual fund category has a distinct risk-return characteristic.

A multi-asset allocation mutual fund under the equity category involves allocation to various asset classes under one portfolio, which could be a good diversifying option for many investors based on their suitability.

[Read: How a Multi-Asset Fund Can Protect Your Portfolio at a Market High]

Why Asset Allocation Matters: The Power of Diversification

The core tenet of asset allocation lies in diversification. By spreading your investments across different asset classes, you aim to mitigate the impact of market fluctuations in any single asset class. When one asset class experiences losses, another might generate gains, helping to smooth out the overall portfolio performance and reduce volatility.

Think of it like building a house. You would not use only one material for the entire structure, as it would be susceptible to specific vulnerabilities. By combining different materials like wood, concrete, and steel, you create a more robust and resilient structure. Similarly, a diversified portfolio built through strategic asset allocation is better equipped to weather market storms.

Graph: Performance across asset classes over the past decade

Data as of February 19, 2024
Do note past performance is not an indicator of future returns
The securities quoted are for illustration only and are not recommendatory.
(Source: ACE MF, data collated by PersonalFN Research) 

As you can see from the above graph, not all asset classes perform in the same direction during a given time period.

The CRISIL Composite Bond Index appears to have had a relatively stable performance over the past ten years, with some fluctuations but no major upward or downward trends. The price of gold has also increased significantly over the past decade. This could be due to a number of factors, such as inflation, geopolitical tensions, and increasing demand for gold as a safe haven investment.

The NIFTY 50 also appears to be volatile, with periods of both growth and decline. Gold emerged as the best-performing asset class among the three in 2023, followed by debt and equity.

[Read: Diversification in Mutual Fund Portfolio-The Secret to Long-Term Investing Success]

However, it’s important to remember that past performance is not indicative of future results, and the relative performance of these asset classes can vary significantly depending on various economic and market conditions.

Even within categories, certain sub-categories and schemes are more sensitive to certain risks, while some are exposed to others. For instance, under equity mutual funds, a Mid Cap Fund is more likely to face sharp volatility in the interim if the equity markets are correct compared to Large Cap Funds; nevertheless, they are likely to generate higher returns over the long run.

Asset Allocation Strategy – 12:20:80

The 12:20:80 asset allocation strategy is a simple and potentially effective approach to diversifying your investment portfolio. It proposes dividing your investable assets into three distinct portions:

• 12 Months of Emergency Fund: This initial 12% allocation is crucial for building an emergency fund to cover unexpected expenses like medical emergencies, job loss, or car repairs. It should be invested in highly liquid instruments like savings accounts, money market funds, or short-term fixed deposits, ensuring easy access to funds when needed.
• 20% Investment in Gold: This portion of your portfolio is dedicated to gold, which is often considered a safe haven asset during economic turmoil or market volatility. Gold can be invested in through various options like physical gold, gold ETFs (Exchange Traded Funds), or gold mutual funds.The rationale behind this allocation is to provide some protection against inflation and diversify your portfolio beyond traditional stocks and bonds.
• 80% Investment in Equity: The remaining 80% of your investable assets are directed towards equities, representing the growth engine of your portfolio. This can involve investing in individual stocks, mutual funds, or ETFs that track various stock market indices. Equity investments offer the potential for higher long-term returns but carry higher risk compared to other asset classes.

[Read: Navigating the Market Landscape: How to Approach Equity Mutual Funds in 2024?]

 (For illustration purposes only)

The 12:20:80 strategy might not be suitable for everyone, as individual circumstances, risk tolerance, and investment goals can vary significantly.

Having said that, if you are a young investor and are willing to take the risk to clock an efficient real return (also known as inflation-adjusted returns), you could broadly follow a 12-20-80 Asset Allocation strategy.

You may begin by setting aside 12 months of regular monthly expenses (including EMIs on loans) into a Liquid Fund and/or Savings Account to address any exigencies, park 20% in gold as a portfolio diversifier and the remaining 80% invest in suitable diversified equity funds as per your suitability. This strategy could potentially offer your portfolio the correct mix of stability, growth, and protection.

Factors Influencing Your Asset Allocation

You see, there’s no one-size-fits-all approach to asset allocation. The ideal mix of asset classes for you will depend on several factors, including:

• Risk Tolerance:  How comfortable are you with potential losses? Investors with a higher risk tolerance can allocate a larger portion of their portfolio to equities, while those with a moderate risk tolerance might favour fixed income (debt) or gold. Those with lower risk could opt for liquid funds, etc.

  – Asset Allocation Pyramid based on risk profile

    (For illustration purposes only)

  The pyramid is divided into five tiers, with each tier representing a different risk level.

  – Top tier: represents investors with a 'Very Aggressive' risk profile investing in high-risk, high-potential-return investments like small-cap stocks or Sector/Thematic funds.

  – Second tier: 'Aggressive,' investors seeking moderately high-risk, high-potential-return investments like mid-cap or large & mid-cap funds.

  – Third tier: 'Moderately Aggressive' investors considering moderate-risk, moderate-potential-return investments like focused or flexi-cap funds.

  – Fourth tier: for investors with 'Moderate' risk profile investing in moderately low-risk, moderate-potential-return investments like large-cap funds, value funds, or index funds.

  – Bottom tier: for 'Conservative,' investors aiming for low-risk, low-potential-return investments like liquid funds, cash equivalents, or bonds.

• Investment Time Horizon:  How long do you plan to hold your investments? Younger investors with a longer time horizon can generally tolerate higher risk, allowing them to invest more in growth-oriented assets like equities. Conversely, individuals nearing retirement might prioritise capital preservation and allocate more towards fixed income and gold.

• Financial Goals:  What are you saving and investing for? Different goals like retirement, education, or a down payment on a house might require varying risk profiles and investment time horizons, influencing your asset allocation strategy.

[Read: Is It the Right Time to Invest in Mutual Funds Now]

Developing Your Asset Allocation Strategy: A Step-by-Step Guide

1. Evaluate your risk tolerance with potential losses through self-assessment tools or consultations with SEBI-registered financial advisors.

2. Identify your short-term and long-term financial objectives, understanding the time horizon and risk associated with each goal.

3. Gain knowledge about the different asset classes, their historical performance, risk-return characteristics, and potential impact on your portfolio.

4. Decide on the desired percentage of your portfolio to allocate to each asset class based on your risk tolerance, time horizon, and goals.

5. Choose specific investment options within each asset class, such as individual stocks, mutual funds, or Exchange-Traded Funds (ETFs).

6. Monitor your portfolio performance and rebalance it periodically to maintain your target allocation, especially when market movements cause deviations.

This article first appeared on PersonalFN here