3 individuals, 2 situations: Importance of asset allocation during market cycles

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“I visualized my grief if the stock market skyrocketed and I wasn’t there, or if it went down and I was completely in it. So I split my 50-50 contributions between stocks and bonds.

– Harry Markowitz, Nobel Laureate for his contribution to modern portfolio theory


“On average, 90% of the variability of returns and 100% of the absolute level of return is explained by asset allocation. ”

-Roger Ibbotson


It’s no less than a roller coaster for equity investors since the emergence of the Covid-19 pandemic, with BSE Sensex hitting a low of 25,981 on March 23 and nearly doubling from that level to surpass 50 000 exactly one year later. .

Of all the investment lessons that have been learned over this period, the most important would be the importance of asset allocation. Let’s look at the example of three fictitious individuals with varying investment psyche and risk appetite as they navigate different emotional states, and the role that asset allocation can play in helping them achieve their goals. Goals.

Take the example of Mr. Courageous, who was 90% exposed to equities before the market crash. When the market hit its low on March 23, 2020, it went into an obvious panic. Unable to cope with further notional losses, he immediately sold about half of his shares.

On the other hand, Mr. Docile had majority exposure to debt and 3% to equities and was in a state of pure bliss. His reaction to Mr. Courageous would have been a bit like saying, “Hey, I told you. Actions are dangerous. He takes no action on his exposure, and after simply stating his opinions (albeit temporarily), it is now even more unlikely that he will ever invest in stocks in the near future.

However, Mr. Balanced had 50% exposure to equities with diversified exposure to debt and gold. Evocative of his name, he was in a less extreme emotional state. As he was exposed to stable assets, he took no action as the rally in gold made up for the losses to some extent.

Now let’s take a look at the value of each of these portfolios (assuming an initial value of Rs 100 and movement between different asset classes) of these people after a full year, as of March 23, 2021, when the market had reached almost double the levels of last year. .

Mr. Courageous with Rs 95 * in his kitten scratched his head in panic and thought “What have I done?” Let me invest some money in stocks now.

Mr. Docile with Rs 108 is in deep regret after missing the bus, and with his hands still tied, takes no action.

Mr. Balanced, ranked # 1 with his portfolio value at Rs 115, is in a less extreme emotional state and takes no action.

These are now hypothetical examples assuming Mr. Courageous sells half of the shares at the low end of the market which may be different in real situations, varying from person to person, resulting in varying end values. for portfolios, based on a simple mathematical calculation of how stocks would have performed over the past year, which has experienced a high degree of volatility. To calculate returns on equity, debt, and gold, Sensex values, the 10-year G-sec benchmark, and MCX gold prices were used.

The biggest learning from this story is that it helps to be like Mr. Balanced at all times when it comes to investing. An investor with a more diversified allocation to various asset classes including stocks, fixed income assets and gold etc. is likely to go through a more emotionally stable journey over a longer period of time.

The very reason for doing the asset allocation is the uncertain nature of each asset class and it is recognition of the preparation for the rainy day in a particular asset class.

Although they are fictional characters, all three types of investors above are present in the real world. For example, the assets under management of equity-focused mutual funds amounted to Rs 13 lakh crore, which is about a tenth of the amount of term deposits.

That’s a lot of Mr. Dociles over there. The sudden increase in the number of mat accounts as a result of the stock market rally indicates herd behavior like Mr. Courageous in the market. Meanwhile, the more than six-fold increase in AUM over the past five years under hybrid funds to around Rs 2.5 lakh crore (Amfi data as of March 31, 2021) shows the presence of behaving investors. in a more balanced way.

While most investors recognize the importance of asset allocation, this is easier said than done, due to challenges such as choosing the right products from among the many options and the influence of emotions during market ups and downs. Thus, it is relevant for an investor to choose the right vehicle to follow the path of asset allocation. The solution to these challenges is surprisingly simple.

One option is the asset allocation fund of funds that invests in equity, debt and gold focused ETFs to build a diversified portfolio for long-term wealth building. These funds follow a systematic and process-driven asset allocation based on a financial model, which primarily takes stock valuation levels into account when deciding exposure to different asset classes.

In addition, within equities, they invest in large, medium and small caps based on the same model. This approach to asset allocation comes with a high level of discipline and takes emotions out of the process. These funds can be suitable for any investor needing asset allocation.

(Naveen Gogia is Executive Vice President and Co-Head of Sales and Distribution at HDFC Asset Management. His views are his own)


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