Invest Wise | Why asset allocation matters, even for HNIs

Adhering to asset allocations will hold you in good stead, market movements notwithstanding

There was a time when the only popular investment  in town was fixed deposits (FDs). We have come a long way, and today  several asset classes are available.

These include direct equity, mutual funds (and within that, a full range of categories such as large, mid and small cap equities, multi-asset funds, debt funds, etc.), high-yield debt, commodities such as gold and silver, international investing, private equity, and many others.

There are many investors (including high net-worth investors — HNIs) who have become so comfortable with fixed deposits that they often forget to evaluate returns factoring in inflation.

Asset allocation forces us to not get fixed on our own notions. Thankfully, while FDs are still a dominant force, they are losing ground, and investors are beginning to build a much more diversified portfolio.

So, the question is: why does that matter?

Also read: Find the best asset allocation mix that will maximise your returns

The significance of asset allocation

Each investment can be looked at from the lens of safety, liquidity, and returns. By creating a blend of investments, we can create a good risk / return profile of our investments aligned to our goals. A single asset class would rarely be able to address all our goals suitably.

Further, if we look at data, all asset classes are cyclical in nature. Equity markets go up and  down, as do interest rates, and so does every asset class based on the underlying investment thesis and market movement. But not all asset classes are correlated. So, when equity markets are up, it is often seen that interest rates are easing. Or when oil prices (i.e., commodities prices) go up, equity markets start getting worried and could have a downward trend. Thus, a diversified portfolio makes  returns a lot less volatile.

Also read: Sensex hits 66,000: What should be your strategy with equity mutual funds?

This is significant, because in theory, equity markets have given 14-15 percent returns over extended periods of time. But when you look at periods of sharp drawdowns, then markets can lose a lot more (for example, the equity market decline during Covid was close to 40 percent). Even seasoned investors develop doubts in these phases.

Any strategy which reduces volatility improves the chances of investors holding on to investments aligned to their goals, rather than panicking. This improves the probability of long term returns and the likelihood of meeting goals, because “time in the market” often beats “timing the market.” The obvious caveat is that the investment should be sound in the first place, not speculative.

Cushion against volatility

An asset allocation-driven investment approach is also helpful in navigating how to deal with one's portfolio in turbulent times. Behavioural finance is replete with examples where investors rush to add to portfolios when the markets are rising, and run for cover when they go down. If we use asset allocation as a yardstick, it provides a buoy to hold on to in troubled times. Let me illustrate this with an example.

Suppose an investor decides that the right level of equity allocation for her is 60 percent. If the equity markets start rising rapidly (compared to other asset classes), soon the allocation would go out of order, with equity weightage becoming, say, 70 percent due to market movement.

The asset allocator would force us to pause and decide if we need to book profits to bring the allocation back to our preferred 60 percent (per this example), or over-ride the trigger and continue with 70 percent equity allocation.

One can choose to remain overweight in equities, but it should be a considered decision rather than just a greedy or peer-driven action. You would not be stuck like Abhimanyu where you enter the chakravyuh of the market, make profits, and then not know when and how to exit.

Likewise, when the market goes down, while the first impulse may be to book losses and bolt, the asset allocator may be flashing that there could be a big bargain available, and all incremental investments or re-allocations should be in favour of equities if other fundamental factors are favourable. This tool is equally applicable to all asset classes.

In the current environment, with the general elections just round the corner, multiple geopolitical hotspots,  inflation still not under control for central bankers globally, and other major factors hanging in balance, it is difficult to predict which market narrative and direction would take precedence in the short term.

In these turbulent times, asset allocation is even more valuable in navigating and decision making.