Stick to asset allocation during turbulent phases in the market

Combining various asset classes in a portfolio can mitigate the risk inherent in a single-asset portfolio

“Diversification is the only free lunch in investing,” said Nobel Prize winning economist Harry Markowitz.   

Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, in their 1986 paper 'Determinants of Portfolio Performance', said: “Asset allocation explains more than 90 per cent of the variability in a portfolio’s total return over time.”  Asset allocation assumes special significance at a time when equity investors in India are facing a market that is in correction mode.  

 

Diversify to reduce volatility

 

Just as variety strengthens an ecosystem, diversity in investing strengthens your portfolio. Investing all your money in one instrument or asset class can expose you to various systematic and non-systematic risks. Asset allocation helps in spreading your investments across different asset classes rather than just one, which in turn helps to balance risk and portfolio returns over time. 

The goal of asset allocation is to minimise risk while meeting the level of return you expect. Since each asset class carries a different risk profile, diversification across multiple asset types helps mitigate the impact of severe downturns in any one asset class. A portfolio heavily concentrated in a single asset class is vulnerable to large swings in value, which could result in significant losses and gains. In contrast, a well-diversified portfolio is better equipped to handle market volatility.   

Asset allocation helps reduce portfolio volatility by combining assets that don’t always move in the same direction. For instance, a portfolio solely invested in S&P 500 stocks delivered impressive returns in 2021 compared to a gold-only portfolio. However, in 2022, the same stock-heavy portfolio saw negative returns, while gold performed relatively well. This highlights the importance of a diversified portfolio, as returns from different asset classes can offset each other, resulting in more stable overall performance.   

Since different assets have varying correlations, combining them (with different weights) allows investors to create portfolios aimed at returns with reduced volatility.  

 

Assess your risk tolerance

 

One of the primary steps in building your portfolio is assessing your risk tolerance. You can then calibrate your asset mix based on the amount of risk you are willing to take. An investor’s time horizon and liquidity needs are other key factors that help in evaluating their risk tolerance. Investors who have a longer horizon and no need for money in the immediate future can tolerate greater volatility (as they can stay invested and weather downturns).   

In general, securities that are riskier provide higher returns. Hence, do not expect equity-like returns from a 50-50 equity-bond portfolio.

 

Rebalance at regular intervals

 

Rebalancing is an important process, as it brings discipline and helps you stick to your investment goal. For example, in a bull market, a 50:50 fixed-income and equity portfolio could shift to a 40:60 fixed income and equity allocation. During such times, rebalancing by reducing equity and increasing debt can help protect the portfolio from capital erosion if a bear market follows.

 

Stay put in turbulent markets  

 

During turbulent markets, one of the biggest mistakes investors make is to view short-term declines in portfolios as 'losses' rather than the natural ups and downs of financial markets.  

 

Before investing, clearly define your investment goal and time horizon. Do not touch your portfolio during the turbulent phases that you are bound face in this journey. Looking at long-term data on the performance of asset classes will also help in decision-making.

 

Many investors allow fear to make them too conservative in their portfolio. Such investors miss out on the long-term growth potential of equities.  

 

To sum it up, it is crucial for investors to get the chemistry of asset allocation right in order to generate optimal returns. Revisiting your portfolio regularly and rebalancing weights is of equal importance. While emotions will play a role, you should be able to stick to your asset allocation no matter what happens in the markets.

 

(The writer is a certified financial planner and founder of Plan Ahead Wealth Advisors, a Sebi-registered investment advisory firm). 

   Performance rotates across asset classes, making diversification essential