Asset allocation and market cycles: Part 1

The last 3 years has been outstanding for the Indian stock market. The Nifty grew at a CAGR of over 20%, despite the sharp correction in 2015 and early 2016. The market continues to remain bullish and there is lot of optimism among retail investors. I certainly do not want to spoil the party mood, but I want to remind our readers that market cycles are inevitable in investing. I have observed that though most investors are aware of this fact, they somehow like to believe that the party will continue forever. I have no idea when the bull market will end, but it surely will. In this post, we will discuss how asset allocation will help you in navigating through market cycles.

Many friends have asked me when a bull market will end. It is impossible to predict. Many Advisorkhoj readers may have experienced multiple bear markets, but for the sake of less experienced investors, let me list some observations about bear markets that I have gathered through years of following the stock markets in India and abroad.

Some characteristics of bear markets

• Bear market strikes without warning and usually strikes when bullishness or optimism is maximum among investors


• They strike with such ferocity that most investors (especially retail investors) have no time to react. By the time retail investors are able to gather their wits huge price damage is already done


• Stock market commentators, who had been predicting another 15 – 20% rise in stock prices on print, TV or digital media, suddenly turn negative about the market


• Every other day brings more bad news and fall in the stock prices. Soon panic sets among all investors, both big and small. Usually, when panic sets in, investors make poor decisions


• From time to time, there is small rally in the market, which brings a false sense of optimism among some investors, but bears use the rally to sell more and cause further price damage


• When the mood is darkest; this is when the market has fallen more than 20% or so, the market experts predict another 20 – 30% fall. But suddenly the market turns around and we see a big rally. Some experts see this as a false dawn, but the market continues to rise and the bear market ends

You can see that, bear markets are very difficult because there is uncertainty. However, not all investors are panicky in bear markets. Smart and disciplined investors are unfazed by bear markets and in fact use bear markets to get even higher returns on their investment. How do they do it? They are well prepared. Most of us are reactive, but smart investors are pro-active. I have discussed a number of times in my blog that, asset allocation is the one of the most important aspects, if not the most important aspect of investing. Unfortunately, most investors do not pay attention to asset allocation.

What is Asset Allocation?

In very plain language, it is about not putting all your eggs in one basket. There are different asset classes like equity, debt, gold etc.; each with different risk / return characteristics. Equity or stocks are the riskiest asset class, but gives the highest return over a long investment horizon. Debt (fixed deposits, bonds, debt mutual funds etc.) is the least risky (safer) asset class, but the returns of debt investments are limited within a range.

The risk / return characteristics of gold is somewhere between debt and equity. Gold is usually counter-cyclical to equity (price movement is usually opposite that of equity) and therefore is a good hedge against equity risks. Many investors in India have the perception that, gold is the safest asset class, but this is an incorrect perception. In the last 5 years, gold gave negative returns in rupee terms. Gold returns are also linked with exchange rates because most of the Gold in India is imported.When Rupee appreciates versus other currencies (primarily the US Dollar) the price of Gold is lower, whereas when the Rupee depreciates the price of Gold is higher. The investment cycle for gold is usually longer than equity. Since gold is slightly complex as an asset class, for the sake of all investors, we will exclude it from our discussion in this post. Needless to say, given its importance in our culture for weddings and other auspicious occasions, gold is an important asset class in India.

You may like to read is equity superior to gold as an asset class

Asset allocation is the mix of different asset classes in your investment portfolio. For the purposes of this post, it is the mix of equity and debt in your portfolio. Equity as an asset class will grow your wealth in the long term, whereas debt as an asset class will reduce the risk and give you income in the short to medium term. Investors need long term capital appreciation, may also need income and at the same time balance the risk of the portfolio. Therefore, you need to have a mix of both equity and debt in your portfolio. The optimal asset allocation for each investor is specific to their financial situation and risk capacity. Younger investors should have a higher proportion of equity in their investment portfolio, because they can have longer investment tenures. Older investors, especially those who are retired or close to retirement, should have a higher proportion of debt, because their risk capacity is lower.

Rule of 100 is a popular asset allocation rule, wherein the proportion (in percentage terms) of equity in your portfolio should be 100 minus you age. So if you are 30 years old, the proportion of equity in your portfolio should be 70%; the balance 30% should be in debt. If you are 50 years old, the proportion of equity in your portfolio should be 50%, the balance 50% in debt. Rule of 100 is a popular asset allocation rule, but by no means the best one in all situations. You should have your own asset allocation depending on your own specific situation. You can consult with a certified financial planner or with your financial advisor to determine your optimal asset allocation; remember, however, that your optimal asset allocation will change over time.

Why is asset allocation important?

Asset allocation will help you meet your short term, medium term and long term goals, by balancing your investment returns with the risk. Asset allocation will also provide you protection from the vagaries of market cycles and help you make the best investment decisions. Consider this example. You have invested Rs 20 lakhs in an equity fund and you will need Rs 10 lakhs in 3 years to make a down payment for home purchase. Let us suppose that, after 2 years, there is 30% crash in stock prices. Even if you got, say 15% returns in the first year of investment, the value of your investment after the crash will be around Rs 16 lakhs. You cannot afford to take a risk, so you will redeem Rs 10 lakhs from the equity fund for your down payment even if the price is down 30%. So you are left with just Rs 6 lakhs, when the market rebounds.

Let us now discuss an alternative scenario. Suppose you invested Rs 12 lakhs in the equity fund and Rs 8 lakhs in a low risk debt fund. Assuming the debt fund gives an 8% annualized return in 3 years you will have enough money to make the down payment. What is the value of your equity fund after the 30% crash, assuming you got 15% returns in the first year? It is around Rs 9.7 lakhs; more than 50% higher than in the previous scenario. If your investment is 50% higher when the market rebounds, your potential wealth creation will be 50% higher. Over a long investment horizon, this can make a significant difference. You can see that, asset allocation not only makes your financial planning stress free (you have a high degree of confidence that you will be able to meet your goal, irrespective of what happens in the stock market), it also helps you make much more money.

Did you know what should be your return expectations from mutual fund

Big market movements impacts your asset allocation

As discussed earlier, different asset classes have different rates of returns on investment. In bull markets, equity gives a much higher rate of return than debt, whereas in bear markets, debt outperforms equity by a big margin. Therefore, if you have a passive approach to asset allocation, market movements will make the asset allocation skewed and jeopardize your financial goals either by exposing to too much risk (higher loss) or too little risk (low returns). Let us understand this with the help of an example. Let us assume your optimal asset allocation is 60% equity and 40% debt. Let us assume equity gives 20% annualized returns in 3 years (around the same rate of return which Nifty gave in the last 3 years). Let us assume debt gives 8% annualized returns. What will your asset allocation be after 3 years? Your asset allocation will be 67% equity and 33% debt.

Going by the asset allocation Rule of 100, this is ideally the asset allocation of someone who is 7 years younger than you; in other words, you are exposed to much more risk than you should be. What will happen if the market crashes 30%? Not only will you lose 27% of your portfolio value, your asset allocation will be 57% equity (lower than your optimal asset allocation) and 43% debt. Furthermore, if you panic and sell equity, which is not unnatural in such circumstances, your asset allocation will be even more skewed towards debt and this will affect your long term goals even more negatively. You can see how market movements affect our asset allocation; this may have an impact on various financial goals.

Conclusion

In this post, we discussed how bear markets are inevitable and the same time unpredictable. We also discussed about different asset classes and why asset allocation should be one of the most important considerations in your financial planning. We saw how market movements affect asset allocation. In conclusion of this post, a passive approach to asset allocation may be detrimental to your financial interests. An active asset rebalancing strategy will help you deal with market cycles and will play an important role in investment management. In the next part of this post, we will discuss how asset rebalancing will help you navigating the difficult waters of market cycles. Please stay tuned…….

In the meanwhile you may like to read another article on asset allocation – Simple asset allocation strategies for different risk profiles