How to Master the Art of Portfolio Construction Through Diversified Asset Allocation

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The foundations of long-term wealth creation are based on an investment charter and asset allocation based on the individual’s risk profile. Global empirical studies have summarized that asset allocation explains the majority of long-term portfolio performance, while only a small part is attributed to the selection of underlying financial instruments.

Therefore, it is imperative to remain focused and disciplined in asset allocation while being tolerant of short-term volatility.

The graph below, with observations over the past 30 years, provides a good understanding of the characteristics of the asset classes.

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Of all asset classes, equities offer the highest long-term capitalization. As the chart shows, domestic equities posted the highest risk/reward ratio, followed by US equities.

Gold by itself is not a great asset class to own, however, it acts as a hedge against increased volatility and can be considered portfolio insurance. Fixed income securities contribute to the generation of stable income with low volatility.

It is important to note that these asset classes have a low correlation with each other over long periods of time, thus providing diversification benefits in an investment portfolio.

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When investing in stock markets, it is important to have a long-term horizon, at least 3 to 5 years. The fundamental reason for investing for a long period is to deal with volatility, which can never be predicted. Therefore, the most successful managers strongly advocate “Time in the Market” as opposed to “Timing the Market”.

To better understand this, let’s look at the journey of the Nifty50 and an actively managed fund over the past 27 years. We assumed 27 separate investments in each of the strategies at the start of each calendar year. The first column shows the returns for the calendar year, while each of the rows shows the compound returns generated at the end of the indicated number of years. For example, over the past 27 years, the Nifty50 has generated a CAGR of 10% versus 18% for the actively managed fund.

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It can be observed that periods of negative or low returns are usually followed by periods of average to high returns. This observation is a simple explanation for understanding that stock returns are not linear and tend to cluster in a few years.

Additionally, active management has a higher probability of successfully generating positive returns over a 5-year period and double-digit returns over a 10-year period. The conclusion we draw from this analysis is that compounding has a much larger effect on investment returns than we realize and that we should be easily swayed by negative returns as they will fade over time.

From a stock market perspective, although the recent budget may cause some disappointment due to the lack of measures to support consumption, the focus on investment spending should accelerate the economic recovery going forward. . With Nifty50 trading at 20X FY23E, corporate earnings growth will become crucial going forward.

The wild card in the pack is the price of crude oil, which is currently hovering around ~90 USD/bbl, which, if it rises significantly, may present the risk of interest rates rising faster than expected, thus reducing risk premiums. We believe that CY22 will probably be a year of consolidation and we suggest a bias in favor of Multicap strategies with additional investments to be made in 50% lump sum and 50% spread over 3 to 6 months.

From a fixed income market perspective, market participants would be eagerly awaiting RBI’s valuation this month, with expectations of a reverse repo rate hike in the upcoming policy account. given the normalization trajectory.

For fixed income portfolios, we continue to suggest following a barbell portfolio approach, i.e. having a core allocation to high-quality, accrual-oriented funds with short maturities (4-6 years), supplemented by an allocation of 20 to 30% towards long maturities and high quality funds. deployment strategies.

Tactical allocation to select High Yield, MLD, REIT, InvIT strategies can help improve the performance of fixed income portfolios.

(Ashish Shanker is Managing Director and CEO of Motilal Oswal Private Wealth)

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