Why should asset allocation be important to your financial planning?

With interest rates rising over the last few months, valuations of Indian stock markets came down despite being marginally lower than global peers.

Separately, the global banking crisis and rupee depreciation pushed Indian gold prices to record highs. The yellow metal was the best performing asset class in FY23 with one year returns of around 14%.

With yields remaining high, long maturity fixed income instruments underperformed.

No single asset class has outperformed or underperformed across all financial years during the said period.

This highlights the importance of a diversified portfolio and appropriate asset allocation. The last thing investors want to see is their investment go down when they really need it.

Equity: The Long Term Play

Domestic equities remained subdued in FY2023. “Indian markets were impacted by a number of factors, including high valuations, supply-chain constraints, hyperinflation and collapse of international banks due to rising interest rates,” said Vinod Nair, head of research at Geojit Financial. Services.

The market is now trading with a negative bias over the long term (18 months). Nifty 50 has given negative 5% returns this year from 21 October 2021 to 31 March on price return basis.

With the correction at this point in time, Nair believes that the market has taken into account the downside to an extent and valuations have come down on a long-term basis.

“While the expected reversal in monetary policy from an accommodative to neutral tone in the coming quarters will be a positive trigger, one of the biggest risks is a slowdown in the economy not being fully factored into future income growth and its impact, According to Nair.

A closer look at the returns reveals that the small-cap segment (represented by the Nifty Small-Cap 250 TRI) was the worst performer in FY23, with negative returns of 6% on a total return basis.

Interestingly, the small-cap segment, which comes with higher risk in terms of volatility, outperformed all other asset classes in five of the 10 financial years. But in the years that saw a recovery, returns from the segment declined sharply, mostly by double-digit percentage declines.

Since small-cap multiples have improved compared to the broader market, Nair believes the small-cap segment looks attractive on a long-term basis as it offers better risk-reward ratio. Note that this segment is only for people with high risk appetite.

For international equities, which serve as a good diversifier for domestic equity-heavy portfolios, we looked at S&P 500 index data. The index has given one-year returns (in rupee terms) in double digits in seven of the last 10 financial years. A meaningful part of such returns can be attributed to the depreciation of the rupee.

The depreciation of the rupee came to its rescue in FY23 as well. Over the past 12 months, the S&P500 index has fallen by about 10%, but a fall of about 8% in the rupee has helped the rupee-denominated index remain almost flat. Talking about the underperformance of US equities, Sahil Kapoor, Market Strategist & Head- Products, DSP Mutual Fund said, “Uncertainty around developments and rate hike by Fed by 475 basis points (bps) weighed on US equity returns.” In the last years, the valuation of the index on PE (price to earnings) basis has come down by 400 bps.”

From here the short-term outlook doesn’t look attractive for US equities either. “Going forward, volatility is likely to persist as growth in the US economy slows and corporate profitability resets to lower levels. Expect the index to remain in a broad range for the next few months.”

However, those investing for the long term should make use of the current correction opportunity through SIPs (systematic investment plans) to tide over the overall volatility, said Kapoor. Note that very few global funds are currently accepting fresh inflows.

Gold: High Volatility

Gold, as an asset class, is highly volatile as compared to equities.

In the last 10 years, it has been the worst performer in four years and the best performer in three years. Furthermore, the best years for gold were the worst for equities.

Again, it was rupee depreciation that supported Indian gold prices to deliver double digit returns in FY23. But. International gold prices remained volatile.

“International gold prices started FY23 on a high note on risk aversion created by Russia-Ukraine war. Tailwinds for price also include multi-year decade-high inflation in the developed world and a pullback in risk assets. But headwinds in the form of a stronger dollar and higher interest rates put pressure on gold during the rest of the year,” said Ghazala Jain, Fund Manager – Alternative Investments, Quantum AMC.

Going forward, the economic slowdown set in motion due to the aggressive monetary policy tightening in the last financial year and the Federal Reserve being very near the end of its tightening cycle will bode well for gold in the near term,” believes Jain. Investment advisors suggest having 5%-10% allocation to gold in the portfolio to counter the volatility.

Debt: Mean Reversion

This year saw the sharpest hike in interest rates by central banks around the world. As a result, yields on debt instruments jumped sharply. The rise in yields impacted the returns of longer-dated debt instruments, which are more likely to be volatile with yield movements.

The CRISIL 10-year Gilt Index returned 3.4% in FY23, better than the 1.1% it delivered in FY22. While the CRISIL 91-day T-Bill Index gave 5.5% in FY23 (compared to 3.7% in FY22).

“Debt markets are reverting to mean. Thus, periods of underperformance are usually followed by extraordinary gains as yields oscillate through rate cycles. We’ve seen yields rise over the past year and are near 10-year lows.” Maturity is reflected in the underperformance of the category. Going forward, as rates stabilize, and even fall, we should look for the performance of 10-year maturity funds to make up for last year’s poor performance,” Sandeep Yadav, Head- Fixed Income, DSP Mutual Fund said.

Having said that, Yadav also highlights that investing in long-term paper is not everyone’s cup of tea. “The asset allocation between these two funds is dependent on the risk profile of the investors. While I believe the 10-year category may outperform the 91-day T-Bill, more risk-conscious investors may prefer the latter,” Yadav said.

Another important development on the debt side is the removal of concessional capital gains tax treatment for debt funds. For investments starting from the current financial year, income from debt funds will be taxed at the slab rate, irrespective of the holding period, which is in line with the tax treatment on income earned from fixed deposits.

asset allocation is key

The performance of each asset class depends on various factors, which retail investors cannot keep track of all the time.

Thus, a good financial plan requires an investor to have a diversified portfolio with suitable asset allocation. Asset allocation has been a time-tested method to prevent losses in any market scenario as it balances the risk and reward aspects of the portfolio. It is nothing but dividing the assets of a portfolio into asset classes according to the goals, risk tolerance and investment horizon of an individual.

Talking about the importance of asset allocation, Renu Maheshwari, Co-Founder, Finscholarz Wealth Managers said, “Picking assets into winning asset classes is a mistake most people make while managing their portfolio. Chasing a winning asset class yields a sub-optimal return on a portfolio. Appropriate asset allocation ensures that the portfolio gets the full benefit of the rally in that particular asset class.”

He reiterated that asset allocation forms the basis of portfolio management and overall financial planning.