Asset Allocation - Strategy To Construct A Solid Mutual Fund Portfolio
Every investor's target is to build a winning portfolio of top performers. A portfolio that can outperform market returns through thick and thin. But is that really possible?
Constructing a solid mutual fund investment portfolio
The year 2024 has been a year with various ups and downs. With the Indian Lok Sabha elections, budget announcements, and American elections, the stock market has witnessed both bull and bear runs. However, this kind of volatility is not exclusive to this year; rather, it is the inherent nature of the stock market. With such market volatility year after year, it becomes impossible to time the market and determine which stock or fund will give the highest returns.
Hence, the question arises: how can one construct a solid portfolio? This is where diversification and asset allocation come in.
Connection between diversification and asset allocation
As rightly said by Harry Markowitz, diversification is the only free lunch in the world. Diversification refers to an investment strategy through which investors can reduce their overall risk by spreading it across various asset classes. To ensure effective diversification, proper asset allocation is essential.
What is Asset Allocation?
Asset allocation refers to strategically distributing a portfolio’s investment into different asset classes, such as equity, debt, and cash instruments. The primary goal of asset allocation is to optimise the balance between the risk and return of an investor’s portfolio.
Importance of Asset Allocation
When judging the performance of any asset class, an investor’s first resort is to look at its past performance. However, it is essential to acknowledge that the winners amongst asset classes change every year, and a well-diversified portfolio is the key to steering through any market condition. Moreover, a research paper by Brinson, Hood, and Beebower indicates that portfolio performance is dictated by asset allocation rather than factors like market timing and scheme and stock selection.
Source - Determinants of Portfolio Performance, Brinson, Hood & Beebower, Financial Analyst Journal (July/August 1986)
Hence, crafting a diversified portfolio with optimal asset allocation is important. Creating a diversified investment portfolio requires a mix of asset classes tailored based on risk profile, financial objectives, and investment horizon.
Rule of Asset Allocation
The rule of asset allocation says that you can determine investment between debt and equity based on you can allocate your assets based on the following formula -
100 - Your age
According to this formula
Your age = % investment in debt
100 - Age = % investment in equity
For example, if your age is 25, 25% of your investment portfolio should be invested in debt, and 75% of your investment portfolio should be invested in equity.
This rule of asset allocation serves as a general strategy and may not be tailored to individual needs. For a personalised asset allocation plan, please consider the points outlined below.
How to create a personalised asset allocation plan?
- Investment objective and time horizon - The investment objective and time horizon play a critical role in optimal asset allocation. The time horizon to achieve different objectives may vary, sinceall financial objectives are unique and have different maturities. For instance, your financial objective of buying a car may have a shorter maturity than your financial objective of building a retirement fund. Longer-term targets may allow for a more aggressive allocation, while shorter-term targets might need a more conservative approach to safeguard capital.
- Liquidity - Your investment strategy can be derailed if you lack access to funds when critical situations arise. Investing in illiquid assets, such as real estate, poses challenges when pursuing short-term financial goals. While real estate offers long-term benefits, its inherent lack of liquidity can lead to delays in achieving immediate objectives. If you don't have the cash in hand when you need it, your investments could suffer.
- Financial position - The first and foremost thing an investor must do before investing is to consolidate all of his earnings, expenses, debts, and assets. This would provide an overall summary of the financial position reflecting on the risk capacity of an investor. Through this, an investor can decide whether to go for an aggressive or a conservative asset allocation approach.
- Risk profile - Analysing risk profile is essential for asset allocation as it ensures that an investor's portfolio aligns with their financial objectives and investment horizon. To develop a comprehensive risk profile, an investor must first define their risk tolerance, which is their willingness to withstand market volatility and the level of risk they can comfortably bear. Next, they must assess their risk capacity, which refers to their ability to absorb potential losses without jeopardising their financial stability. By evaluating both factors, an investor can form a balanced risk profile, enabling them to allocate investments across different asset classes.
- Age - As one can infer from the asset allocation rule mentioned above, younger investors with longer investment horizons are in a better position to assume higher levels of risk, meaning they have time to ride the waves of market volatility in the long term and can follow an aggressive asset allocation strategy. On the other hand, older investors, or the ones who are about to retire, may have a shorter investment horizon and, hence, should follow a conservative asset allocation approach.
- Taxation - Taxation plays a pivotal role in the decision to allocate assets as it directly impacts the net returns investors earn from their investments. Different asset classes are subject to varying tax treatments, making it essential to focus on post-tax returns, which reflect the actual income retained after taxes. Tax-efficient investments, such as ELSS mutual funds, can reduce taxable income while optimising returns.
Mistakes to Avoid During Asset Allocation
- Not Reviewing and Rebalancing - Over time, market movements can cause the portfolio's asset mix to drift away from the intended allocation. Without regular reviews and rebalancing, this drift can increase risk or reduce potential returns, as the portfolio no longer aligns with the investor’s original objectives. Hence, for the best results, investors should regularly review and rebalance their portfolio.
- Emotional biases - Investor’s emotions, such as fear during downturns or greed during market highs, can lead to impulsive decisions that deviate from the planned asset allocation. Such biases can result in chasing returns or abandoning strategies at the wrong time, undermining long-term financial objectives.
Comparison of Different Asset Classes
Different asset classes, like gold, silver, bank deposits, company deposits, and Sensex, have performed differently in the long term. However, the returns of Sensex beat other asset classes by far. Moreover, equity as an asset class provides high inflation-adjusted returns. The chart below shows a comparison of the performance of different asset classes in the last 15 years (from March 2009 to March 2024), along with their inflation-adjusted returns.
Source : Inflation - RBI as on Mar 2024 (Note: Inflation data before 2012-13 is taken as per WPI rate & from 2012-13 CPI rate is considered.)
Gold & Silver - RBI data as on Mar 2024
Bank Deposits & Co. Deposits - RBI data as on Sep 2023
Sensex - BSE data as on Mar 2024
Equity mutual funds invest in Sensex. Hence, for professional management and diversification of your investment portfolio along with optimal returns, you can consider investing through equity mutual funds.
Conclusion - Seeking guidance from a financial advisor or a mutual fund distributor
To conclude, the quest for building an optimal portfolio with proper diversification and asset allocation should be guided by the factors mentioned above rather than simply selecting top-performing investments. For the best results, the portfolio must be optimally divided into different asset classes based on fundamentals rather than performance.
Moreover, it’s important to recognise that a tailored, well-diversified portfolio is key to long-term success. While top-performing assets may seem attractive in the short term, they may not align with your risk tolerance or future needs. Therefore, a thoughtful and balanced approach, considering tax implications, market conditions, and personal circumstances, is crucial for building a resilient and growth-oriented investment strategy. Furthermore, asset allocation is not a one-time decision - it should evolve as your financial situation, objectives, and market dynamics change. Hence, regular portfolio reviews and rebalancing are very important.
Choosing the right asset allocation may seem like a challenging task, and hence, an investor should opt for the guidance of a financial advisor or a mutual fund distributor to invest in mutual funds, which can help investors make informed decisions.
Frequently Asked Questions (FAQs)
1) Why is asset allocation important?
Asset allocation is important because it helps to reduce overall concentration risk through diversification. It allows investors to navigate market volatility and can significantly influence portfolio performance over time.
2) Should I seek guidance for achieving optimal asset allocation?
The short answer is YES. You should always seek guidance to invest your hard-earned money. A mutual fund distributor can help you in optimal asset allocation in mutual fund investing.
3) Who can guide me in achieving optimal asset allocation in mutual fund investing?
To get personalised guidance on asset allocation and hand-holding throughout your mutual fund investment journey, open an E-Wealth Account with NJ Wealth and get a dedicated mutual fund distributor for all your mutual fund investment related needs.