Taking investing decisions can be difficult because of the cyclicality of the market and the cacophony of noise around us – there are a host of so-called experts with often conflicting recommendations - that are shouting from all sides with what they think is the best idea over the next 3/6 months or longer. Things get further complicated given the large number of asset classes and portfolio vehicles available and the uncertainty regarding future performance.
Since most people are not comfortable with uncertainty, this has the potential to cause real harm to the portfolio – endless procrastination while the money stays idle, or complete eschewalof all risk in the quest for certainty(at the cost of lower portfolio returns). Even when allocation is made to riskier assets subsequent ups and downs can cause dissonance. Thus most investorsend up maintaining a much lower allocation to volatile asset classes like equity compared to what may be appropriate for their needs.
Seemingly the only way out of this dissonance for most investors has been to invest in a good market cycle. When our tentative first investment achieves healthy returns, there is no dissonance and it gives us the required confidence to invest and increase allocations further. Unfortunately this strategy has ended up being a recipe for disaster for many as the allocation tends to get more and more lop-sided as that asset class runs higher and higher, and when the (inevitable) correction comes, investor losses can be much more significant than the returnsmade earlier in the cycle.
Diversification and Asset allocation reduce uncertainty and improve portfolio outcomes
Diversification has been called the only “free lunch” in financial markets. What makes diversification so powerful? How can it protect the investor from getting hurt by the uncertainty or risk of investing in any asset? By mixing a number of different asset classes with different properties – essentially ensuring that all eggs are not in one basket.
Let us look at an illustration.Assume a “high potential return” asset A, and a “medium potential return” asset B. Assume A can give a 3 year return of 20% compared to B which can give 17%. However A is more volatile – that is its price fluctuates much more – compared to B. Here are the numbers:
As can be seen above – for the patient buy and hold investor, A delivers a higher return in the end. However the ride is really bumpy – with maximum losses of 50% of the initial investment. In the case of asset B, the total return for holding is lower but with a reduced volatility. However the real story is what happens when we create a mixed portfolio that invests half in each of the 2 assets - by adding a 26% returning asset to an18% returning asset we have got a portfolio return of 34%! The outcome seems unreal – How did this happen? Is there really a “free lunch”?
Here’s the secret behind the success of diversification:
Reduced loss – The addition of a lower risk instrument reduced the loss at the end of year 1. While portfolio A was down 50% at that stage, C (the 50:50 portfolio) was only down 26%. Larger the loss, the more difficult it is for the portfolio to come back.
Lower correlations – While A and B seem to be moving in the same direction, the extent of change is different. For example, A has a better return in year 2, while B has a better return in year 3
Rebalancing – Portfolio C at the end of every year has rebalanced its allocation to 50:50. That is at the end of year 1, when A under-performed relative to B, it sold B and bought A. This helped the portfolio participate in the good returns given by A in the subsequent years.
Asset Allocation in practice
The 3 ingredients described above ensure successful diversification benefits over the long term – but has it worked in practice with real market data?The answer is an unequivocal yes. Let us see the 2 following examples using real long term market data.
- Multi asset funds investing in domestic asset classes – a triple asset portfolio that invests within Indian equity, debt and gold will diversify the risk from a single portfolio that invests only in Indian equity. History has shown that such a portfolio has a lower risk and yet higher return as compared to investing only in equity.
- Use of offshore funds – Combining a global diversified equity fund to an Indian equity portfolio. Once again, while Indian equities have out-performed global equities in this period, a 20% allocation to global equity actually improved the risk and return profile of the portfolio.
The above are only 2 examples of how asset allocation can be used by investors. In reality, asset allocation can add value to all long term investors – whatever be their risk profile or portfolio objectives. Asset allocation also inculcates discipline and protects us from getting swayed by short term market movements. Rather than worrying about what any investment or asset class may do in the next 6-12 months, all investors will be well advised to focus on what their appropriate long term asset allocation should be and then work to get their portfolio aligned to that target.
The illustration provided above is for the purpose of explaining the concept of diversification. There is no guarantee or assurance that performance/returns depicted above will be achieved. Past performance may or may not be sustained in future