The economic and financial dislocation from the Coronavirus (COVID-19) pandemic seems to be subsiding. The shock factor of the infection, the clampdown on economic activity and personal mobility has given way to adjustments and a new way of work and life. This is most clearly visible in the financial markets where stock indices have bounced back strongly from the lows and valuations are now back to the pre-COVID-19 levels.
Asset allocation is one of the most important decisions for any investor. The right mix of assets is a bigger determinant of the long-term performance of that portfolio than a big move in say stocks or gold prices. This is because all assets follow a cycle and could have a long period of underperformance followed by episodes of superlative gains. Besides, when one asset does well others languish. So allocating money to various assets in the right proportion is important for minimising risk and maximising gains over the long period of time.
Here are some tips to spread your money across popular assets such as stocks, gold, bank fixed, money market mutual funds and high yielding corporate deposits or bonds. The idea is to achieve the right mix of returns and risk diversification.
1. The first step is to decide the share of each asset class in your portfolio. For example, if you plan to invest Rs 1 lakh every year, how much of it should you invest in equity; what proportion should be in gold and how much should go towards various kinds of fixed income instruments. This is determined by your risk appetite; how long you can keep the money locked-up in an asset and what financial goal you wish to achieve through the portfolio.
2. It is important to look at risk adjusted returns rather than headline returns.
In simple terms volatility is a big swing in asset prices on either side from its trend line or the average price. For example, consider a stock that doubled in price in the last three years. This translates into annualised return of nearly 26 per cent. But what if the stock or the index in question is very volatile and halved in value in the second year followed by another big positive swing in the third year? This may trap many investors who may need money just when stock prices were down forcing them to book a loss on their investment.
In contrast fixed income assets such as bank fixed deposits, bonds, money market mutual or corporate fixed deposits have very low volatility or underlying risks with often pre-determined returns if one decides to hold them till maturity. Lower risks however come with low potential returns and a fixed income only portfolio may not be sufficient for you to achieve your financial goals.
3. Inflation is another factor to keep in mind while working on asset allocation. A well balanced portfolio should not only provide positive returns, it should be well above the rate of inflation during the holding period. This ensures that when you redeem or sell your portfolio, the proceeds should enable you to buy more goods and services than when you started. In the last five years, consumer inflation in India has been around five percent per annum. In other words, a basket of goods & services that cost Rs 50,000 five years ago will now cost around Rs 64,000.
This means that you should aim for annual returns of well above 5-6 percent to start making money in real terms. It also means that it’s not a smart idea to keep most of your money in savings accounts with banks.
4. Now how to achieve the right balance of return and risks in the Indian context? To answer this, we sifted through the last 25 years’ data on the Nifty 50 index, gold prices and interest rate movement in the money market and historical yields on banks’ FDs to get a handle on returns and underlying risks involved. (See the table below).
As expected, the equity has given the best returns in the last 12 years followed by gold and investment grade corporate deposits.
An investment of Rs 10,000 in a diversified portfolio of stocks mirroring Nifty 50 index in 1996 is now worth Rs 1.23 lakh, translating into annual returns of 11 percent. In the same period, Rs 10,000 worth of gold is now valued at Rs 80,000 while Rs 10,000 fixed deposited in a bank would have grown to Rs 62,000.
Superior returns in Nifty and gold come with high volatility or swings in year-on-year returns. Nifty is the most volatile with standard deviation of 19.4 percent while it is 12.7 percent for gold. In other words, in a typical year, potential returns from Nifty can vary from -6.7 percent to 32.1 percent.
To balance out this volatility, you need a significant exposure in low risk assets such as fixed deposits, bond funds and money market mutual funds. If you are young, equity can be the lion’s share of your portfolio but as you grow old, dependence on equity becomes too risky.
5. Our simulation suggests that a portfolio with 25-30 percent allocation to stocks, another 15-20 percent to gold and the rest equally divided between bank FDs, money market mutual funds and high yielding corporate deposits has yielded the best combination of risk and reward in the last 25 years.
Such a portfolio has given annualised returns of around 9 per cent in the last 25 years with a standard deviation of 5.6 percent. In other words, a Rs 10,000 investment in such a portfolio is now worth around Rs 80,000. An equity allocation beyond 30 percent leads to a sharp rise in return volatility without any significant rise in average annual returns.
Another alternative is to create a portfolio with 10 percent allocation to equity, 25 percent to gold and the rest to fixed income. This yielded annualised returns of 8.6 percent with standard deviation of three percent.
Readers can also consider these as base case scenarios and choose to go overweight or underweight on a particular asset depending on the short term tactical opportunity.
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).