Year 2020 has just begun and we have already experienced high volatility across the globe in this short period. While fears over the US-China trade war receded, the Coronavirus scare brought the Chinese economy into a standstill. The global signals kept the Indian markets on an edge even as the domestic indicators have been quite significant, including increasing slippages in the asset quality for the banks indicating corporate stress and the economic slowdown.

However, the signs of green shoots in economic growth, duly supported by regulatory interventions and liquidity support, have been pushing the equity and debt markets higher.

Considering that bellwether equity indices are trading near lifetime highs, investors might not be comfortable investing at such expensive valuations. However, at the same time, the fear of missing out (FOMO) is pushing them to have a meaningful investment exposure in equities so that they do not miss out on future market rallies that might come on the back of a revival in economic growth. This is indeed posing a dilemma for the investors as they find themselves see-sawing between higher valuations and better economic outlook.

Emerging strong

The financial markets have been emerging strong after almost a year of liquidity strains and elevated yields. Since the corporate tax rate cut in September 2019, the pressure on the tax collections was largely expected, especially as the government had itself anticipated a revenue loss of Rs 1.45 lakh crores. Such a revenue shortfall, along with the slippage in divestment targets, had led the debt markets to anticipate a higher fiscal deficit than targeted.

This was indeed the reality as the Union Budget estimated the fiscal deficit at 3.8 per cent of GDP against 3.3 per cent of GDP projected earlier. However, the fiscal prudence and commitment to fiscal consolidation injected a fresh lease of life into the debt markets. Further, the recovery in the financial markets was fuelled by the RBI’s regulatory actions to aid smooth transmission of lower policy rates and spur the credit growth.

Diversification helps

Given the mixed signals across the equity and debt markets, diversification across asset classes instead of having all investments in a single asset class can help reduce the risks amidst an environment of uncertainty as the underperformance in a single asset class may be compensated by some other asset class that is doing better.

Even the historical performance of different asset classes and even within the sub-categories of different asset classes bears testimony to this fact that no single asset class has been consistently outperforming the other asset classes. This is because different asset classes tend to react differently even to similar macroeconomic situations, thereby allowing the markets to generate varying returns for the investors.

A small illustration of the historical performance over the last four years can throw a meaningful light on the importance of asset allocation.

G-Secs, which outperformed the markets with 15 per cent returns in 2016, generated a meagre 2 per cent return in the next year. Year 2017 was dominated by the outperformance of small-cap stocks with 59.6 per cent returns, followed by the negative 23.5 per cent returns in the following year by the same category.

Gold was able to outperform other asset classes in 2018 with only 8 per cent returns. While the strong run of gold continued in the next year as well with 18 per cent returns, international equities helped the investors generate the best returns of 27.3 per cent.

Given the mixed bag of returns for investors across years, it becomes imperative for the investors to adopt an optimal asset allocation strategy to achieve the financial goals over the long term.

Aligned with risk

Staying diversified across asset classes helps the investors to reduce concentration risk within the portfolio. Further, the presence of different asset classes can help the investors align their investment portfolio with the risk profile as different asset classes are generally linked with varied risk-reward trade-offs.

For example, a conservative investor may like a higher debt allocation in his/her portfolio, while an aggressive investor may choose to have a higher allocation towards equities. In the current era of uncertainty in global markets, the investors may also want to mitigate their investment risks by allocating a small portion of their investment portfolio in gold as well.

Regular reviews

Maintaining an asset allocation strategy requires regular efforts in terms of periodic review and rebalancing of the investment portfolio as the return expectations and risk-bearing ability of the investors may change over time.

To ease such investment decisions, one can also consider investing in balanced advantage funds wherein the asset allocation is decided based on relative valuations of equity and debt.

Further, such periodic rebalancing also helps to book profits regularly when the asset class is trading at relatively higher valuations. As such, the lower exposure during times of expensive valuations helps investors protect the returns already earned and, thus, mitigate their investment risk.

Maintaining an optimal asset allocation strategy can help investors to stay on track of their investment journey and achieve their financial goals over the long term.

The writer is ED and CEO, Nippon India Mutual Fund