Mutual Funds

In asset allocation, diversification is the key

Dhiraj Relli | Updated on September 29, 2019

Dividing your portfolio across asset classes helps limit risks, and reduces volatility of returns

Many equity investors have witnessed substantial erosion in value of their investments, owing largely to a fall in the value of mid- and small-cap stocks. One reason for this could be their entry into the market at the fag end of the rally. Investing a chunk of their wealth in equities, not booking profits in a timely manner at higher levels, or a combination of both could be the other reasons. On the whole, a lack of discipline has been the undoing of most investors.

These turbulent times have taught investors a lesson — the importance of asset allocation. Appropriate allocation across asset classes ensures that the investor participates in diverse investment cycles, while factoring in risk. All asset classes do not match in terms of either the opportunities or the downsides they offer at different points in time.

Asset allocation is the practice of dividing the investment portfolio into various classes such as stocks, debt, real estate, gold and cash, based on individual preferences, goals and risk profiles. One can also look at crypto currencies, algo trading, art, commodities, etc.

Why diversify

Asset allocation essentially helps diversify assets, limit risks and reduce the volatility of returns. One can also take exposure to global assets and currencies through global equity funds or direct investments in assets abroad. Within equity, one can allocate across capitalisation to control risks or optimise returns. The sum of these diverse investments is expected to offer improved the risk-and-expected-return characteristics relative to the parts.

Asset allocation decisions depend on three key factors — risk tolerance, investment objectives and time horizon.

While reviewing asset allocation, one may also do scenario building, which helps identify possible pathways towards a vision of the future. One may have a strategic horizon of five-plus years and a tactical horizon of rolling one year, and one may go back and forth between a long-term horizon and an intermediate horizon, so that the probability of reaching the future goals increases.

Young investors with no major liabilities could have higher exposure to equities. However, for an investor whose income is volatile in nature, the best option is to keep a majority of savings in easily cashable instruments. An investor’s preference for immediate or total returns is also relevant.

Prior to the allocation of funds across asset classes for the purpose of investment, an adequate life insurance cover, and funds for emergencies should be kept aside.

Invest right

Gold allocation should ideally be 5-10 per cent of an investor’s wealth. Debt allocation can be anywhere between 20 per cent for a young professional and 60 per cent for a retired person. The balance can be invested in equities.

In rising markets, if the allocation towards equities, which has automatically risen, is not corrected in time, it may lead to losses when the tide turns and the market plunges. A portfolio with too many asset classes or stocks becomes unmanageable.

A portfolio review (say, half-yearly) is advisable. While allocating assets, post-tax returns should be considered, i.e., tax-efficient investing. Investors must choose avenues that can help counter inflation rates over the long term.

They must understand the concept of investing, rely less on tips, hearsay and rumours, and more on self-study and analysis.

Though there are no short-cuts or guarantees in the process of investing, maintaining a reasonable and disciplined approach will increase the likelihood of success over time.

The writer is Managing Director and CEO of HDFC securities

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Published on September 29, 2019
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