People spend too much time picking the right fund/stock and trying to time the market. Research has shown that the primary decision of how much to invest in stocks, debt and other asset classes is the primary driver of a portfolio’s performance, over the long term. Kirtan ShahFounder, Credence Wealth Advisorstalks about what goes into building a diversified portfolio.
During a bull run, people hardly talk about debt and gold. It is only during a volatile market that asset allocation comes into play. How important is asset allocation when investing?
Asset allocation is like a fire extinguisher. No one uses it until the fire breaks out. When you have an 80:20 debt allocation and we’re in a bull run, investors complain that the 20% debt allocation doesn’t make as much money as stocks. It’s only when the market falls that the 20% allocation to debt and gold becomes a savior.
When the market corrects, investors wait for another correction. Also, people tend to run out of money when the opportunity arises.
There are several types of asset allocation strategies like constant, tactical and dynamic weighting. The type of asset allocation one adopts depends on the risk profile, time horizon and other factors. Personally, I follow a dynamic and tactical asset allocation strategy. I reduce my exposure to equities by switching to debt/gold when valuations get high. Also, one could shift to a value theme when the markets are accelerating.
Asset allocation typically tilts towards equities during a bullish period. Many newbie investors get into stocks during these times. What are the dangers of investing in a single asset class?
In the last 30 years of the market cycle, you would probably have had five instances where your portfolio experienced a 30-60% crash. When you approach investors during a crash, they feel the markets would fall further or don’t have the cash to invest. That’s why this 30% allocation to cash and debt will help you buy when the markets crash. Even having a 100% debt portfolio is not desirable. Investors will not be able to beat inflation. Mismatch in both equity and debt can be a problem.
Investors are considering international diversification, but there are currently too many options. How can investors add international funds as part of the asset allocation?
There are emerging and developed markets. The kind of growth we are seeing in India is unprecedented. So we don’t need to invest in another emerging markets fund. If you wish to expose yourself to a particular theme such as the electric vehicle (EV), then you can consult specific funds. The cumulative return of the MSCI Europe market has been 3.5% over the past three years. The cumulative return of the S&P has been 46% over the past three years. About 40% of that S&P return was attributable to shares of Facebook (Meta), Amazon, Apple, Netflix and Google (FAANG).
When considering diversifying into developed economies, thematic investing makes more sense because a large portion of the return is generated by a theme. Of course, it is difficult to identify which sector would do well. One could therefore consider having exposure to a US market, which will add global diversification to your portfolio.
Isn’t it hard to predict which theme would work? Even in India, we have too many thematic/sectoral funds. How do you choose these funds?
You have to do a lot of reading and research. A theme can stem from government policy, geopolitical developments, industry changes, and more. For example, globally, there has been a shift from diesel and gasoline to electric vehicles. India is now working on ethanol. Ethanol is a subsection of the larger topic of electric vehicles. If you followed the budget and government comments, there has been a huge push towards manufacturing to reduce reliance on imports. Real estate is another emerging theme right now. If you look at the relationship between income and the price of real estate, it’s at its best for 20 years. You need to keep an eye on what is happening around you.
When it comes to international investment, should you opt for active or passive funds?
Most investors struggle to understand the nuances of fund performance. This is usually done through a fund-of-funds structure. Investors therefore need to understand the international fund and the domestic FOF that are channeling the money. If we are unable to understand the nuances of the market, liabilities make more sense.
How important is downside protection when building a portfolio of different asset classes?
The first thing I look for when screening funds is the downside protection ratio. If the markets fall 50%, you need a 100% rise to reach your initial investment. If you are able to hedge against the downsides, your upside potential can be considerably higher than investing in a fund that goes down more and rises more. I would prefer a fund that drops less during downturns.
All fund managers go through a cycle. I have not come across a fund that has performed well every year. They follow a particular theme and that theme goes through a cycle. Whenever you think market valuations are expensive, allocate fresh money to value-oriented funds. Invert when valuations are cheap. When you feel the markets might rebound, opt for momentum, passive or growth funds.
What role do valuations play in choosing your equity allocation?
Some investors are willing to buy bargains at any valuation. But it is wise to buy them at reasonable valuations. Valuation is an important determinant in the choice of stock valuation. It is applicable when deploying new and existing silver. We think the value tends to do well when the markets get expensive. Stock market valuations have been expensive for a year. You will notice that growth funds have done well in 2021. In contrast, value funds have done well despite investing in large caps.
What is the main source of return for a portfolio? Is it asset allocation or good stock/fund selection?
From my interaction with fund managers, I have learned that a large part of performance comes from good sector allocation. If your sector allocation is correct, even an average stock would do well. That said, some fund managers place more emphasis on bottom-up stock selection. When selecting funds, we consider whether the three main sectors where the fund is overweight are likely to perform well. No one is consistent. Every fund goes through a cycle. No fund will remain popular for ten consecutive years. If you have a well-diversified portfolio of Indian stocks, international stocks, debt, and gold, you’ll get a decent risk-adjusted return rather than trying to time the market.
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