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How to master the art of portfolio construction via diversified asset allocation

The foundations for long term wealth creation are built on an investment charter & asset allocation as per the individual’s risk profile. Empirical studies globally have summarized that asset allocation explains a majority of portfolio performance in the long term, while only a small portion is attributed to the selection of underlying financial instruments.

Hence, it is imperative to stay focused and disciplined towards asset allocation while being tolerant of short term volatility.

The below chart, with observations over the last 30 years, provides a good understanding of asset class characteristics.

ashish shanker chart1ETMarkets.com

Amongst all asset classes, equity offers the highest long term compounding. As can be seen from the chart, domestic equities have exhibited the highest risk-reward, followed by US equities.

Gold by itself is not a great asset class to own, however, it acts as a hedge against heightened volatility and can be considered as insurance in the portfolio. Fixed Income helps in steady income generation with low volatility.

Importantly, these asset classes exhibit low correlation to each other over long time periods, hence providing benefits of diversification in an investment portfolio.

ashish shanker chart2ETMarkets.com

When investing in equity markets, it is important to have a long term horizon, at least 3-5 years. The fundamental reason for investing for a long time period is to deal with volatility, which can never be predicted. Hence, the most successful managers strongly advocate ‘Time in the Market’ as opposed to ‘Timing the Market’.

To understand this better, let’s look at the journey of the Nifty50 and an actively managed fund over the last 27 years. We assumed 27 separate investments in each of the strategies at the start of every calendar year. The first column shows the calendar year returns, while each of the rows indicate the compounded returns generated at the end of the stated number of years. E.g. over the last 27 years, the Nifty50 has generated a CAGR of 10% vs. 18% for the actively managed fund.

ashish shanker chart3ETMarkets.com

ashish shanker chart4ETMarkets.com

It can be observed that negative or low return periods are typically followed by medium to high return periods. This observation is a simple explanation for understanding that equity returns are non-linear and tend to be bunched up in a few years.

Also, active management has a higher probability of successfully generating positive returns on a 5 year period and double-digit returns on a 10 year period. The conclusion that we derive from this analysis is that compounding has a much larger effect on investment returns than we realize and that we should get easily swayed by negative returns as they will fade with time.

From an equity market perspective, while there could be some disappointments from the recent Budget on the absence of measures to shore up consumption, the focus on capex is likely to augment economic recovery going forward. With Nifty50 trading at 20X FY23E, corporate earnings growth delivery will become crucial going forward.

The joker in the pack is crude oil prices, currently hovering at ~USD90/bbl, which if they rise significantly can pose a risk of interest rates rising faster than expected thus reducing risk premiums. We believe CY22 is likely to be a year of consolidation and we suggest a bias towards Multicap strategies with incremental investments to be done as 50% lumpsum & 50% staggered over 3-6 months.

From a fixed income market perspective, market participants would be looking forward to RBI’s assessment during this month, with expectations of a hike in reverse repo rate in the upcoming policy given the normalization path.

For fixed income portfolios, we continue to suggest following a barbell portfolio approach i.e. having a core allocation to high-quality accrual oriented funds with short maturities (4-6 years), complemented by 20-30% allocation towards long maturity and high-quality roll down strategies.

Tactical allocation to select high yield strategies, MLDs, REITs, InvITs can help enhance the yield on fixed income portfolios.

(Ashish Shanker is the MD & CEO of Motilal Oswal Private Wealth)

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