Home / Money / Personal Finance / How befriending asset allocation will help you in the investment journey
3 min read . Updated: 26 Nov 2021, 06:13 AM IST
One thing common between what is happening in the markets right now and March 2020, other than the ongoing covid pandemic, is the question on investors’ mind: “Where, from here?" Since economic activity was hit due to the pandemic last year, financial markets have been volatile. The S&P BSE Sensex dipped to multi-year lows in March 2020, falling by 37% since the start of 2020 and then rose nearly 2.4x by October 2021. The 10-year G-Sec yield during this period has also been extremely volatile, having dipped to 5.8% in May 2020 from 6.5% in January 2020; they are up again to 6.3% in October 2021.
Today, when the equity markets are at an all-time high and bond yields are said to have seen their lows, the question that keeps coming back to investors’ minds is still the same. “Where, from here?" No one has the answer to this; but there is someone who can see you through market uncertainties, your best friend in your investment journey—asset allocation.
While it is certain that markets will trend upwards in the long term, it’s also certain that this journey will not be completely smooth. There will be bouts of correction in the market, and you definitely don’t want these periods of volatility to eat into a large part of your investments. Investing across asset classes such as equity, debt, gold, etc. can help diversify your investments and will reduce the overall portfolio risk. Chart 1 illustrates the average correlation between the three asset classes during the period between April 2005 to October 2021.
Low correlation implies that the relationship between the said asset classes is not strong and will likely not deliver the same returns as another in a given period. It is this disparity in performance that helps mitigate risks in the portfolio as the weak performance of one asset class could get offset by the relatively stronger performance in another. Thus, a mix of asset classes will offer optimum risk adjusted returns. Chart 2 captures the calendar year performances of an equity and debt index each along with the returns for a 50/50 hybrid index. There are two ways to go about diversifying your portfolio—the DIY or do-it-yourself route or rely on the expertise of professional fund managers. A proper asset allocation requires a deep understanding of all asset classes and specific instruments thereunder. It can be a bit arduous to track all the market and economic parameters and adjust the portfolio as market dynamics change. Furthermore, rebalancing the portfolio to reflect the optimum asset allocation would potentially incur various charges such as exit loads, short-term or long-term capital gains tax, and other transaction costs, as applicable. However, if you are not someone who tracks the market on a daily basis and is unaware of the nuances of each asset class, then the second option is for you. You can manage the asset allocation needs of your portfolio by investing in hybrid funds.
Calendar year returns (in%)
Hybrid funds invest in different asset classes. This diversification enables you to participate in the upside in rising markets and helps protect against the downside in a falling market. Moreover, the appropriate asset allocation mix based on market conditions is managed within the fund by the fund manager and does not lead to any extra charges/costs/taxes.
The decision to invest in these funds should be based on your current portfolio, time horizon and risk appetite. These funds invest a higher portion of the portfolio in fixed income securities offering stability and a small part of the portfolio in equities that can offer capital appreciation opportunities. Aggressive hybrid funds have a higher allocation to equities and a small portion is invested in fixed income securities. If you are comfortable taking relatively higher risk and wish to primarily invest in equities, then this can be the fund for you. Then there are dynamic asset allocation funds which have the freedom to change their asset allocation based on fund managers view on the market. These funds tend to increase exposure to equities when markets are expected to move up and reduce equity exposure when markets start showing signs of correction. This enables you to participate in the market rally as well as have a cushion in times of market corrections.