The less the relationship or overlap between the various asset classes in which you invest your hard-earned savings in, the lesser will be the chances of losing money through the vagaries of the financial world.
“Yes, maintaining a low correlation between various asset classes is crucial for effective diversification,” says Rahul Bhutoria, Director and Founder, Valtrust. A low correlation between your investments in the various asset classes, ensures that when one asset class experiences volatility or decline, the others remain unaffected or may even perform well, thereby reducing the portfolio’s overall risk.
Generally speaking, asset allocation falls into the following categories, fixed income, equities, gold and international equities.
“While doing asset allocation, that is diversifying your portfolio, the correlation between the various types of asset classes should be kept low as it can mitigate the impact of market downturns on the entire portfolio, therefore, enhancing the stability of the overall portfolio,” says Priti Rathi Gupta, Founder of LXME.
Please note that the different asset classes tend to perform well in different economic situations, hence a low correlation between the various types of asset classes enables an investor to benefit from a range of market conditions.
Overall, this enables them to manage the risk, optimise the returns, and achieve their financial goals.
“Low correlation means that the prices of these assets classes (stocks, bonds, gold, international equities) do not move in tandem, so when one asset class performs poorly, others may perform well, thus helping to mitigate overall portfolio risk,” says Anurag Jhanwar, Partner and Co-founder, Upwisery Private Wealth.
Diversification across uncorrelated assets can potentially enhance risk-adjusted returns and reduce the overall volatility of a portfolio.
They act as a protection against various market scenarios as different asset classes respond differently to economic factors. Thus, stocks generally do well in an expanding economy, while bonds tend to perform better in a slowing economy. Gold often acts as a hedge against inflation and uncertainty. By having a mix of assets, your portfolio gains resilience against different market conditions.
Remember those wars in Gaza and the Ukraine. The rising prices of oil. Remember the frustration that you felt at these events that were outside your control and yet were affecting your investments? Well, there is something that you can do about such events.
To buffer against headwinds like wars, political events, inflation, and negative news, investors should maintain a well-diversified portfolio across asset classes where the key is low correlation.
Additionally, having a portion of the portfolio in defensive assets (like gold or certain fixed-income securities) can offer protection during volatile times.
Staying informed, flexible, and ready to adjust the portfolio in response to new information is also vital. This is where tactical allocation comes in. During such times one can consider rebalancing the portfolio and using the cash generated to enter into asset classes that have become attractive or opportunities that will have a significant growth due to the event.
Experts guide how you should look at your investments in the various asset classes so that you can achieve this low correlation between the various asset classes and keep your investments safe.
“There’s a popular thumb rule for Asset Allocation, the 100-age rule, which says that let’s say your age is 30, then 100-30=70% of your money can be allocated towards equity and the remaining 30% in debt and gold,” says Gupta.
It gives a starting point and a broader understanding of asset allocation while investing money. Then, you can overlay your financial goals to fine-tune the asset allocation, customise your investments as per your needs, and hence provide you more flexibility.
Ultimately, investing is personal and unique to the individual, influenced by factors such as risk tolerance and time horizon, etc.
“A basic allocation might include a mix of 50% equities (split between domestic and international), 30% fixed income, and 20% in alternatives like gold and emergency funds,” advises Bhutoria. Adjustments should be made based on personal circumstances and market conditions.
But how do you go about this asset allocation? Assuming that you want to do your investing on your own and don’t want to reach out to an expert, how do you go about this investing research?
“Investors can differentiate between the correlation among asset classes by utilising available online data for research and analysis,” says Gupta.
Investors can also study the historical trends of how different asset classes have performed in different market conditions.
But first you have to know yourself, rather your personal goals, risk appetite etc.
The simple term ‘Asset Allocation’ is the key to achieving all the financial goals, which ensures that investments are well diversified and planned as per the risk appetite, time frame, etc.
An ideal asset allocation between debt, equity, and gold serves the purpose efficiently.
But of course each of the asset classes has its own defining characteristics that the experts lay out for us.
Fixed income, provides steady income and lower risk compared to equities. However, it is sensitive to interest rate changes. An investor can look at a portfolio with varying duration to manage interest rate risk. A higher allocation can be kept towards a particular duration based on the interest rate cycle.
Equities offer high growth potential but come with higher volatility. Dividend-paying stocks can provide income. One should look at the long-term horizon and also stagger investment over a period of time. A rebalancing between different categories of funds will be needed.
Gold acts as a hedge against inflation and currency devaluation. It is less correlated with other asset classes, providing diversification benefits. SGB, gold ETFs or digital gold may be better from a monitoring perspective. This should be looked at as insurance and not from a return perspective.
Finally, international equities offer exposure to global markets, potentially higher growth in emerging markets, but carry currency and geopolitical risks.
But as always the main point is that you have to know what are your investment priorities and the (possible) exigencies that you may have to cater to.
“Before Investing, retail investors should educate themselves about different asset classes, their characteristics, the risks involved, and potential returns. Understand the trade-offs between risk and reward,” says Jhanwar.
Diversify, Diversify, Diversify: Spread your investments across various asset classes with low correlations to minimise risk. This helps mitigate losses from any single asset class performing poorly.
Invest for the long term: Focus on the long-term potential of your investments and avoid chasing short-term trends or making impulsive decisions based on market fluctuations.
Rebalance regularly: Periodically review your portfolio and rebalance it based on your target asset allocation.
Stay informed, but unemotional: Keep yourself updated on financial news and market trends, but avoid making emotional decisions based on short-term market volatility. Stick to your long-term plan and investment strategy.
Start early and invest consistently: The power of compound interest works best over extended periods. Starting early and investing regularly, even small amounts, can significantly benefit your long-term goals.
Seek professional advice when needed: Consider consulting with a financial advisor or investment professional, especially if you’re unsure about your investment strategy or need personalised guidance. A professional advisor can help you develop a customised investment plan tailored to your specific needs and circumstances.
“Diversify your investments to manage the risk and returns!,” says Gupta.
“Asset allocation is not a set-and-forget strategy. Continuous learning, staying informed about global economic trends, and being adaptable are key to successful investment,” says Bhutoria.
Characteristics of the various asset classes
Equity: The value creator asset class
Pros
- Suitable for long-term goals (3+ years).
- Provides inflation-beating returns in the long run.
- Provides the ability to invest in multiple companies/sectors, allowing further diversification.
Cons
- Returns are not fixed, they are variable.
- Volatile asset class.
- Higher risk compared to other asset classes.
Debt: The protector asset class
Pros
- Suitable for short term goals (less than 3 years) and provides stability to your overall portfolio.
- Provides steady returns.
- Lower risk compared to Equity and less volatile.
Cons
- Returns may not beat inflation in the long run.
- Subject to interest rate and credit risks.
- Limited growth potential as compared to equity, during times of economic growth.
Gold: The protector asset class
Pros
- Suitable for long-term goals (3+ years).
- Acts as a hedge against inflation.
- Gold is a great diversifier and adds a good store of value to the portfolio.
- Considered as a safe haven during uncertain times.
Cons
- May not provide inflation-beating returns.
- Volatile asset class.
- Storage, Insurance costs, risk of theft, making and design charges, in case of physical gold holdings.
International equities
“Investing in international equities can add more diversification to an investor’s portfolio, adding a flavour of international market movements, however, there are various other factors that one must consider before diving into international equities such as currency rates risk, understanding of the foreign markets, their rules and regulations, tax implications, etc.” says Priti Rathi Gupta, Founder of LXME.
Mistakes that investors make in investing in the various asset classes
1. Suitability: Blindly following the trends or recommendations without understanding the specific asset class, its risks, and its suitability for their portfolio.
2. Past returns: Assuming that an asset class which has performed well historically will continue to do so can lead to disappointment.
3. Emotional decisions: Panicking and selling during market downturns or chasing hot trends (FOMO) without understanding (Crypto, derivatives, etc.)
4. Investing in overly risky assets
5. Ignoring or not understanding diversification: Diversification within an asset class is not true diversification. Eg: buying 20 different Equity MFs is not diversification.
6. Failing to consider time horizon: Investing heavily in volatile assets like equities for short-term goals exposes the investor to unnecessary risk, as short-term market fluctuations can be significant, as per the Upwisery Private Wealth.
Manik Kumar Malakar is a personal finance writer.
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Published: 11 Mar 2024, 02:32 PM IST