Asset Allocation: The Critical Process In Portfolio Construction

At elevated equity index levels, there is considerable discomfort on the expensive valuations in several pockets of the market. Fears of a possible recession in the US and the expectations on the Federal Reserve’s steps have clouded the interest rate scenario globally. Gold has had a steady run in the last couple of years.

As an investor, things can be a bit overwhelming during such situations. Therefore, it is critical to follow what the legendary fund manager Ray Dalio says: “The most important thing you can have, is a good strategic asset allocation mix.”

To reach all goals, an investor must spread investments across equities, bonds and gold – or funds tracking these – in a suitable proportion to reflect personal risk appetite, time horizon and investible surplus.

Diversification Across Asset Classes

Equities are the wealth creators in an investor’s portfolio given their ability to beat inflation and deliver healthy returns over the long term. But equities have their own cycles of consolidation, rapid rallies and corrections in course of generating robust returns. For example, the Sensex consolidated for 10 years from 1992-2002 with 3% compounded annual returns. But over the next five years, it generated a spectacular 43% CAGR, before correcting by over 50% in CY 2008. For the better part of the 14 years up to December 2023, the Sensex delivered 15% annually.

Debt or fixed-income instruments play the role of providing stability and steady returns to the investor’s portfolio. The idea is to generate steady cashflows in the form of interest or coupon payments without taking too many risks. The CRISIL Composite Bond Fund index has delivered an average of 7.3% returns on a 5-year rolling basis over March 2007-December 2023.

Gold is an asset class that functions as a hedge against inflation as well as global macroeconomic as well as geopolitical risks. It can have periods of strong rallies and price corrections. Returns can thus be lumpy. For seven years from 2006-2012, MCX gold prices rose at a CAGR of 25.7%, followed by a period of nil returns for nearly the subsequent six years. For the five years leading up to December 2023, gold prices rose at 14.5% annually.

In the 15 calendar years from 2009 to 2023, the Sensex and gold have been the best performers for 7 years each, while debt has outperformed in one year.

Thus, winners among asset classes keep rotating on changing frequently based on a whole host of economic, industry-related and global factors, which determine the market cycles.

There is also negative or low correlation among these asset classes. Therefore, a combination of such asset classes – equities, bonds and gold, for example – ensures adequate diversification and lowers portfolio volatility.

A host of hybrid, multi-asset and asset allocator fund of funds options are available for retail investors.

Risk-Adjusted Performance

Asset allocation works to reduce portfolio volatility and helps generate healthy risk-adjusted returns. By ensuring reasonable participation in all asset class rallies, while insulating the portfolio during corrections, asset allocation ensures that you reach your financial target.

Over the short, medium and long terms, asset allocator fund of funds and multi-asset allocation schemes have done better than individual benchmarks such as the Nifty 50 TRI, CRISIL Composite Bond Fund Index and the Gold ETFs category average.