Learn with ETMarkets: Why the universal mantra for wealth creation is nothing but asset allocation

We all have heard the term asset allocation before. Some may also know that asset allocation determines over 90% of portfolio returns. But how well versed are we with the concept of asset allocation? There are a lot of myths and misconceptions about what, why, and how of asset allocation. Let’s quickly understand a little about asset allocation before we jump to action points.

On average, there is a difference of 15% between the performance of the top 25% and bottom 25% asset classes each year. In other words, the difference between getting your asset allocation right and getting it wrong is 15% per annum. Admittedly, that’s a significant number. Nevertheless, it allows you to maximize your wealth over the long term. But how?

It’ll be unrealistic to believe that we can capture the complete difference by picking the best asset classes every time. However, there is a method to capture a 10-12% difference. This method involves two components – Diversification and Dynamic Allocation.

First, let’s see how diversification works. Imagine that you have invested your money equally across all asset classes. As a result, your portfolio performance will always lie between the top 25% and the bottom 25% of asset classes. This simple concept will help you capture 7.5% of the total 15% difference.

Second, comes Dynamic allocation. Dynamic allocation involves predicting the movement of the asset classes and changing the portfolio weights. So instead of all asset classes having equal weight, asset classes with better prospects will have an overweight while the ones with a poor outlook will have underweight. If the accuracy of your prediction is 70% to 80%, you will be able to capture another 3% to 5% difference.

Now, turning our focus to what’s happening around us. There is an exciting chain of macroeconomic events. The unprecedented shock due to the Covid-19 pandemic, followed by the war in Ukraine, brought supply under pressure. The fallout of this was rising commodity prices. Central banks worldwide are raising interest rates aggressively to cool down inflation. Rising interest rates are leading to slower economic growth. There are estimates that the US will go into recession later this year. While there are concerns about growth, stock prices have corrected by 10%-20%, and valuations do not seem unreasonable.

Considering the current environment, here are some portfolio strategies to help you do better with your asset allocation.

What to do with your debt allocation? Within your debt allocation, you should take advantage of the rising yields. Invest in target maturity debt funds maturing between 3-5 years.

Like fixed deposits, these funds will help generate a fixed return at maturity. Also, if yields go up further, coupon reinvestments will happen at a higher rate, thus increasing the overall return.

What to do with your equity allocation? For your equity allocation, look at stocks and funds which have gone through and done well during periods of high inflation, rising interest rates, equity valuations, etc. Creating a blend of value and growth in your portfolio can offer better risk-reward, specifically if your portfolio is heavily tilted towards the growth style. For example, dividend Yield stocks generally are good bets during inflationary periods. However, before you buy dividend-yielding stocks, note that many high dividend-paying companies could be a value trap. During such times, invest in equities through a Fund instead of trying to experiment on your own.

What are other asset classes worth exploring? To tackle rising inflation, explore investments beyond debt and equity. Asset classes such as Real Estate and Precious Metals are known to preserve value during inflationary phases. Instruments such as REITs, INVITs, SGBs, and Gold ETFs are a convenient option to take exposure to tangible assets. For the wealthy, some Long-Short funds or market-neutral strategies will also benefit portfolio diversification. Open up to innovative investment but study the risks very critically.

What to do with your short-term or high-risk capital? If you have funds left after deploying in your core portfolio, you might want to explore some opportunistic or high-return investments. Short-term, high-yield bonds are an excellent investment for someone looking to invest for 12 to 18 months. Evaluate the credit rating and invest in bonds of companies with stable financials. Likewise, private equity investments in early to late-stage companies have a high return potential. Still, given the tightening liquidity scenario, one should be very selective about picking the companies and the pricing.

Finally, to truly benefit from the power of asset allocation and long-term investing, please ensure that your asset allocation is aligned with your risk appetite. Determine how much loss you can handle and factor that into your asset allocation strategy. As an investor, you must be comfortable with your portfolio at its worst. An expert can help you create an appropriate asset allocation to suit the prevailing environment and manage risk on an ongoing basis.

(Vaibhav Porwal is the co-founder of Dezerv)

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