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With literally thousands of stocksbonds and mutual funds to choose from, picking the right investments can confuse even the most seasoned investor. However, starting to build a portfolio with which mutual fund or stock to buy might be the wrong approach. Instead, you should start by deciding what mix of assets in your portfolio you want to hold – this is referred to as your asset allocation. You should consider an asset allocation strategy based on your

  • Time horizon: Asset allocation will depend on how long can you hold on to that particular asset and whether you need it for a particular goal. If you need any of your assets for let’s say a down payment for your house which is due next year, then probably holding debt/fixed income oriented instruments is an option you should consider. Examples of debt include Bank or Corporate Fixed Deposits, short term bond funds, short term bonds and ultra short term or liquid Funds. On the other hand if you have a long term goal like retirement, you can allocate a large portion to equity oriented instruments and lesser towards fixed income oriented instruments. As you move closer to the goal, you can keep reducing the equity portion while increasing the debt component.
  • Risk tolerance: This is different for each one of us. An individual should have a realistic understanding of his or her ability and willingness to stomach large swings in the value of his or her investments. Risk tolerance will depend on age of an individual – middle aged individuals generally tend to be more risk tolerant, as they may have more capital available for investing and have longer term goals.

 

In a volatile market scenario like the one we are witnessing now, and have also witnessed in the past, asset allocation becomes all the more important. The table below shows Sensex High and low on various dates. It also shows percentage fall from high. As you can see , the 1 year returns are as high as 105.9% from April 2003, but are also accompanied by a negative 1 year return to the tune of -31% from January 2008 during the US subprime crisis. Thus, had someone invested all of their money in equity prior to 2008 without a proper asset allocation in place, he would have incurred high losses in 2008. If someone would have invested keeping their goals, time to goals, risk tolerance, savings and expense pattern in mind, they could have held on to their existing investments while strategically rebalancing their portfolio as against panic selling and booking losses. The situation that we are facing now in 2015 around the Greece bankruptcy crisis and Chinese slow down have also resulted in Indian markets correcting significantly. The fall might look attractive to a lot of investors, and they might start buying irrespective of the asset allocation they might have charted for themselves. In our opinion, such events will come and go, and it will always be a challenge for investors to know how much further they could fall. Therefore instead of trying to time the market or haphazardly investing in what looks attractive,e one should go by ones pre defined asset allocation, because what looks attractive today may lose its sheen tomorrow.

Table 1 : SENSEX fall history

UntitledSource: Bloomberg, Reliance Mutual Fund

Historically, broad asset classes move in relation to each other are fairly consistently (for eg., when stocks are up, bonds tend to be down and vice versa). In diversifying the allocation across asset classes, you can potentially create a portfolio with investments that do not all move in the same direction when the market changes. However, if you only spread investments only by industry (eg. automobiles vs. pharmaceuticals), they are all in the same asset class (i.e., all in equities) and respond similarly to market changes. You are therefore open to much greater market risk. Asset allocation helps keep volatility in check.

Ultimately, there is no one standardized solution for allocating your assets. Individual investors require individual solutions. Asset allocation is not a one-time event , it’s a life-long process of progression and fine-tuning. Empirical data shows that it pays to be diversified across asset classes.

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