Asset allocation is a risk mitigation strategy


Suppose you have a goal of 1 crore to meet your child’s education after 15 and you can save 25,000 each month for this purpose. Then, in this case, you would need an annual return of 8.3%. This return will define whether you should take high or low risk. Also, while you may need to take risks, you may not have the tolerance for loss defined by the maximum degree of uncertainty that can be tolerated.

How much risk can you take?

You might feel “ok” with a 10% market correction, as it only takes an 11% gain (from these levels) to recoup your full losses. But a 20% loss, for example, is “more difficult,” since it will take a 25% gain to break even. By the same logic, a 40% loss can seem “overwhelming” because it takes a 67% gain to recoup that loss, and a 50% loss even more so, because it takes a huge 100% gain to recoup your losses. .

Most investors start to get nervous when the market crashes beyond 30% and panic when it crashes beyond 40%. So the big question is: how much drawdown can you realistically handle? It is therefore necessary to create a maximum loss plan.

What can investors do?

Since 2000, Indian stock markets have experienced a correction of more than 30% in a calendar year on six occasions. In 2000 and 2001, stock markets fell even more, by 43% and 42%, respectively, while in 2008 they fell by 65%.

So let’s assume that the likely maximum loss is 40% in one year in most cases. So what is the maximum loss you are willing to take in your portfolio. Let’s say it’s 20%. Next, divide your maximum portfolio loss by the maximum stock market loss that could possibly occur. In this case, that would be 0.20 divided by 0.40 = 0.50 or 50%! So your target equity allocation should be around 50%.

Also, it is very important to determine your equity sub-components. Investing in mid-cap and small-cap funds, for example, carries higher risk and therefore could have the potential to see a larger withdrawal from the portfolio.

Likewise, investing in a few stocks or relying too heavily on employee stock options (ESOPs) increases the threat of non-diversification.

Equity and debt valuation change frequently, and asset allocation should change to reflect this. So, for example, in a 50/50 stock:debt allocation, if the stock appreciates 30% in one year and the debt portfolio appreciates 6%, the stock:debt allocation will change to 55 :45. To ensure that the portfolio does not have a more than acceptable potential drawdown, reduce the share of equities to 50%. Similarly, in a core-satellite portfolio structure, you need to protect the core from the vagaries of the satellite portfolio.

Yield maximization

After losing 50% in a year, it would take a 100% gain to get back to the same levels. And staying invested can speed up the process. How is it? Often, investors lose market gains by trying to time the market.

A study by Motilal Oswal shows that more than 50% of the best 30 days in the past 30 years have occurred during bear markets. And getting out of it could mean losing an opportunity. In the case above, if the market were to gain 10% every year after a 50% correction, it would take seven years to recoup all your losses. Why not 10 years? Thank the power of compounding!

During the 2002-2008 bull run, Nifty 50 increased almost sixfold, from 1,100 in January 2002 to 6,300 in January 2008, a CAGR of 33% per year. However, it has seen seven double-digit percentage declines, including two as steep as 30% during this period. Similarly, from May 2014 to August 2021, Nifty 50 grew 2.5x, at a CAGR of 13%. But, in intermittent times, there were five disadvantages of more than 10%, including two of more than 20%.

So, stay put because good feedback will eventually follow. The best investors focus on risk management that matches their long-term goals.

Anup Bansal is Commercial Director of Scripbox.

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