Is asset allocation only between equities and debt?

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Why is asset allocation always between stocks and debt? Is it fair to do asset allocation and rebalancing between gold and equity mutual funds?

Does asset allocation and the balance between gold and equities (50:50) yield more returns than 100% equities?

Diversification is an important aspect to consider when building your portfolio, as it protects the portfolio against any adverse movement in a single asset class/security. Asset classes (equities, fixed income, gold, commodities, real estate) and even securities within an asset class respond differently to the same set of economic drivers, and therefore to the benefits of diversification.

Diversification is the basic principle of asset allocation.

The idea behind effective diversification is to gain exposure to assets that behave differently from the same set of factors. Therefore, an approach based on asset allocation (combination of various assets) is advisable for investing in a goal, as it improves the risk-return potential of the portfolio and provides a less volatile portfolio experience.

However, it is advisable to have your risk appetite assessed before deciding on asset allocation, as it should be in line with the investor’s risk appetite.

As mentioned above, asset allocation doesn’t always have to be just between stocks and debt, it can involve any combination of asset classes. But since you specified equity and gold, let’s take a look at them.

Fixed income gives stability to the portfolio.

Shares play a crucial role in building long-term wealth with the potential to provide higher inflation-adjusted returns than fixed-income securities.

Gold plays an important role as a diversifier in a portfolio due to its low correlation to other asset classes and is considered a safe haven asset in times of global risk aversion sentiment. It is considered a store of wealth and a hedge against inflation and currency depreciation.

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Gold’s importance as a diversifier has been re-established even as recently as the start of 2020, as it saw a decline of just 11% (S&P GSCI Gold Spot Index) versus a 38% drop by the Domestic stocks (S&P BSE 500 TR Index) in the COVID-19 pandemic led to a sell-off in global markets.

The chart shows (CY returns) that a 50/50 portfolio of stocks (S&P BSE Sensex TR Index) and gold (S&P Gold TR Index) outperformed a stock-only portfolio during 3 out of 5 last calendar years. Even over longer periods, it has outperformed an equity-only portfolio over multiple 5-year periods (see the rolling returns chart).

In addition to debt and gold, consideration should also be given to an allocation to international equities (10-25% of your equity allocation) which provide exposure across geographies with exposure to various economic growth drivers, and also provide a hedge against rupee depreciation. International equities have a less than perfect correlation with domestic equities, which provides diversification benefits to the portfolio.

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Valuations play a crucial role when entering any asset class/security. Lower (cheaper) valuations reduce the risk of high future capital loss and improve upside potential, and vice versa. One must be aware of the valuations prevailing at the time of the investment and make allocations accordingly.

Read: Look at valuations, not index levels

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