Smart Investing: Why You Should Stick to Asset Allocation

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Pursuing a particular target price is only worthwhile if you have expertise in that asset and have a finger on the market dynamics

By Joydeep Sen

Some basics don’t change, even with changing times. The basis or rationale for your portfolio allocation is one of them. Along with changing times, market dynamics change, new investment opportunities emerge, and you can also develop new prospects. However, the importance of asset allocation still remains the same. Why?

  • Markets are uncertain, no one knows for sure how much stocks or gold will yield over the next year.
  • However, from the pattern of historical behavior of this investment asset, there is a broad perspective on the expected return over an adequate investment horizon and the level of risk to achieve this objective.

The essence of portfolio allocation is two-fold: (a) matching the risk profile of the investment asset with your risk profile and (b) diversification into various assets reduces your portfolio risks in a certain extent.

Current market level
What you have just read is not a new discovery. So why repeat? The reason is that at present, part of the investors are trying to assess the current level of the market, which implies making the portfolio allocation in accordance with this judgment. Common refrains are like this:

  • Equity markets have outperformed fundamentals, valuation levels are not cheap, so equity allocation should be lower;
  • In debt/fixed income, interest rates are low and accrual levels are not attractive, real returns net of inflation are negative, so why invest in debt?
  • Gold prices have fallen, unless there are indications of rising gold prices, there is no reason to invest in gold.

These arguments may be correct, but that is irrelevant. These are not the basis for deciding your portfolio allocation anyway. Note, you have no control over market levels or returns. What you control is your wallet. What you do should be rational and in your own best interest, and not driven by emotion, hearsay, or non-expert opinion.

Portfolio breakdown
The rational approach is that the past behavior of stocks, debt or gold or another investment asset tells us broadly what to expect over an adequate holding period; given the risks of that asset class, the degree of allocation that would suit you, and the extent of the negative correlation between those assets, helping you to reduce the risks in your portfolio.

Let’s look at another perspective. Is there a risk in ignoring current market levels? Not a lot. When you invest at a certain market level, say stocks at a certain valuation, the current P/E being above the historical average or fixed income at a certain interest rate level (currently it is lower according to the ‘history), it influences your returns for a while, let’s say next year for the sake of discussion. However, over the long term, the market dynamics of this asset take over. Therefore, as long as you have a long enough horizon, you can afford to ignore the entry-level situation. Moreover, if you enter the market at a favorable time – for example, stocks at a cheap valuation or fixed income securities at a high interest rate, an adverse event may occur in the short term and have impact on your returns. Over the long term, the markets tend to stabilize and regain their level.

Conclusion
To do something, there is an innate reason and there is an apparent reason. You need to declutter your thoughts and see what drives your investment decisions. Pursuing a particular target price is only worthwhile if you have expertise in that asset and have a finger on the dynamics of the market. Otherwise, follow the portfolio approach with appropriate diversification, depending on your investment objectives.

The writer is a business trainer and has written books on wealth management

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