Light of clarity in gloomy market gripped with anxiety

As we approach Diwali, the festival of lights, investors are looking for more light and clarity in a market gripped with fear and anxiety. We have witnessed various macro and micro headlines on a daily basis, causing markets to fluctuate.

Correction in broader markets started earlier this year in February – March, while the Nifty continued to chug along aided by surges in select heavyweights. Rupee was on a decline from August this year due to tightening rates in the US and surge in oil prices. The perfect storm hit markets in September when one of our premier finance institutions defaulted on some of its debt obligations.

This was a scathing attack on an already fragile market at a time of the year when liquidity runs dry due to advance tax payments and half yearly closing. In the face of such news flow, investors may find themselves taking impulsive decisions or conversely, becoming paralysed and unable to implement an investment strategy. Investors have witnessed a hit to a large part of their returns and thus, will naturally feel pained.

During bull markets, there is an illusion of calm and stability which may have pushed us to take more risk than desired. Hence, this is a time to rethink your ability to take a risk and reallocate at an opportune time. Although one must take steps to address any issues in one’s portfolio at this juncture, we maintain that it is highly important to have a long-term perspective and discipline as these qualities help investors to remain committed to their long-term investment objectives through periods of market uncertainty like the one we are seeing now.

One must keep in mind that while equity offers superior returns in the long run, it also exposes one to certain volatility which is inherent to the nature of the asset class. You cannot have one without the other. This is what markets are witnessing in this scenario. So does one react to random movements of the market or can one prepare in advance so as to wade through volatile times?

This is where your asset allocation and investment charter comes into the picture. Prudent allocation to multiple asset classes not only minimises an investor’s risk but also makes returns more predictable and consistent. If one were to compare the performances of different asset classes such as equity, debt, gold, and cash over the past 14 years, one would observe that no asset class has been a consistent winner.

Yet, if one had allocated one’s portfolio equally in these asset classes for the said period, one would make an average return of approximately 11.0% (See chart above), which is way above tax-free bonds. More so, there has been only one instance in the last 14 years wherein the strategy would have given negative returns that too very marginal. This includes periods of global financial like the 2008 crisis where most of the markets were battered.

Merit in diversifying

Thus, there is clear merit in diversifying assets across different asset classes as it reduces dependency on a single asset class and protects from market turbulence. Based on your risk taking appetite, one should decide on how much money needs to be allocated to different asset classes. There are multiple factors that define your risk tolerance level such as investment horizon, liquidity needs, investment goals and so on.

An investor with high-risk tolerance may be willing to accept greater volatility in pursuit of higher potential returns and may allocate a higher percentage of the portfolio towards higher risk assets.

On the other hand, an investor with low-risk tolerance may have to forego higher potential returns for a steadier and less volatile portfolio. If one selects a portfolio with equity and fixed income, the potential gains that the equity component can give are much higher and the associated risk can be well taken care of by the fixed investment component. Thus, a portfolio invested across asset classes has the ability to generate a superior risk-adjusted return. Having thrown light on asset allocation and its merits, we believe an investment charter makes the approach more full proof. Firstly, where does an investment charter fit in and what are its benefits? In the current investment world, investors seek advice from multiple advisors who, more often than not, have a limited understanding of their overall assets.

An investment charter lays down tailor-made rules for your portfolio so as to achieve your long-term goals. It increases the probability to reach your goal by ensuring that you adhere to a suggested allocation over time and varying market environments.

In order to ensure that undue risk is discouraged and emotions are kept away while making investment decisions, it lays down broad guidelines with respect to asset class levels, managers, security level, credit and locked in products etc. Although the asset allocation decision is one of the cornerstones for achieving an objective, it only works if the allocation is adhered to over time and through varying market environments, such as the current one.

Periodic rebalancing will be necessary to bring the portfolio back into line with the allocation designed for the objective. The asset allocation should be periodically checked keeping the investment charter in mind and the portfolio should be rebalanced if it deviates by more than an agreed percentage from the target.

Thus, a combination of a well thought out asset allocation ratio along with a custom investment charter is the way to plan for one’s financial goals.

(The writer is a head of Investment Advisory at Motilal Oswal Private Wealth Managment)