Asset Allocation and Diversification to Build a Balanced Portfolio

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Marketopedia / Importance of Personal Finance / Asset Allocation and Diversification to Build a Balanced Portfolio

Asset Allocation, an Introduction

An asset is any possession owned by an individual, while a liability is one’s financial obligations.

Anything can be considered an asset – from livestock, gold and stocks to bonds, collectables, art, copyrights and trademarks. The list is endless!

 

When it comes to assets, such as bonds, you benefit from cash flow in the form of interest payments. Other types of holdings, such like art, don’t pay out and are instead focused on transferring wealth into the future.

Time value of money

Currency is an asset that is designed to depreciate over time. Furthermore, central banks set an “inflation target” to dictate this rate of depreciation. The US Fed has a goal of 2%, whereas the RBI in India aims for 4-6%. Sadly, 2020 closed with inflation coming in almost 7%. Keeping money tucked away does little good; instead, one should invest their wealth for better protection against loss of purchasing power.

Different type of assets

Precious Metals

Since time immemorial, individuals have been in pursuit of efficient ways to store, transport and trade wealth. Finally, after a long search, gold and silver became the preferred medium of exchange and eventually established themselves as stores of wealth.

  •       They are rare, ensuring a limited supply.
  •       Takes work to mine, purify, mould, etc. This puts a floor on additional supply.
  •       Easily understood, measured and assayed.
  •       Sufficiently dense so that small quantities representing large notional values can be moved around easily.

It should come as no surprise then that gold is seen as a must-have asset. Investors flock to it when other investments are being affected by volatility, and for savers from countries with past experiences of socialism, gold often forms a large portion of their savings. This demonstrates the importance of owning gold as an investment or savings instrument.

Real-estate

Real-estate investing covers a variety of areas such as land speculation, rental-housing and commercial property. Each comes with its own distinct features and size considerations. It’s important to note that no two properties are identical – they can’t be traded like gold or moved from one place to another. As a result, every investor dealing in real-estate has their own unique experience.

Collectables

Famous pieces of art, baseball cards, stamps, rare coins and much more are all known to maintain their worth over time. To make investing in these items a smoother experience, there is now an established ecosystem of services that validate, market and store collectables.

In the last 10 years or so, digital collectibles like bitcoin have enjoyed a surge in popularity. The greatest advantage of them is their divisibility – for instance, bitcoin is currently worth more than $40,000; however, you can purchase as little as ten dollars’ worth of it if you’re just starting out.

Financial Assets

Exchange-traded assets, such as stocks, bonds and commodities, enjoy the advantage of standardised procedures and consistent adherence to laws and regulations. This provides assurance to investors that they will always get what they pay for while also protecting them from any bias in the distribution of information or clearance of transactions on the exchange.

The most sought-after of these assets are stocks/equities, followed by bonds/fixed-income. Commodities come next in line. Derivatives, which are tied to the performance of an underlying stock/bond/commodity, have now eclipsed the market for the three main assets in terms of size.

Since the 1980s, electronic exchanges have allowed for an immense increase in the amount of various asset types that can be traded. Previously, these assets were rendered illiquid due to physical delivery requirements or geographical restrictions, but through derivatives and ETFs, they have seen a massive wave of liquidity.

– Allocation

The act of splitting one’s savings between the different types of assets described above is called “asset allocation.”

Prediction is impossible

If you could determine which of the assets would provide the highest yields, you could invest all your funds in it. Unfortunately, there is no definitive answer to that query.

For example, take US and Indian stocks. For the decade between 2001 and 2011, Indian stocks massively out-performed US stocks.

But performance completely inverted in the next decade.

Who knows what is going to happen in the next 10 years?

Once prices start to grow, the justification for those increases are used again and again with no end in sight. Long term movements build stronger tales; think of “India shining,” “secular stagnation,” or “home prices always go up.”

The only way to protect yourself from decades of underperformance without having to predict is to buy a little bit of all assets.

 – Sequence Risk

An average investor rarely sees average returns.

Markets have been around for centuries, but an investment’s lifespan is not more than a few decades. This leads to all sorts of misconceptions regarding averages and risk capacity.

Investor: On average, over the last 20 years, the NIFTY has given a CAGR of 10%. So, if I invest Rs 1 lakh for 5 years, I should get at least Rs 1.61 lakhs, no?

Me: No. Consider yourself lucky if you don’t lose money.

Investor: But it has given negative returns only 4 years out of 10. I can survive 2 years of negative returns.

Me: Let me tell you something about sequence risk. Sequence risk means that it is possible that you could have all of those negative 4 years during the 5 year period that you have invested.

Many people in the investing world are not conscious that while averages may be accurate on a large scale, they might not have time to witness their own results reflecting the figures.

It is possible to reduce the risk of investing by spreading your funds across a collection of assets that do not move in the same direction.

– Diversification vs Diworsification

 

A basket containing chicken, turkey, goose, quail, pheasant and emu eggs may seem diversified on paper, however it is of no practical use if dropped.

Having an understanding of the dynamics of each asset class is essential when constructing a diversified portfolio. It is important to be aware of the influences of each on one another, in order to ensure that it has a balanced risk profile.

Vectors of diversification

The different vectors that impact returns of various assets, as well as their correlations to each other, are taken into account through diversifying one’s portfolio. This helps to ensure minimal overlap of investments. Here are some examples.

Currency exchange rates

Gold is traded in international markets; as a result, its future value in India is determined by global demand as well as the USDINR exchange rate.

Market composition

Indian equity markets tend to be largely dominated by “old economy” stocks, while tech (“new economy”) stocks are the primary players in America’s. Thus, individual allocations for these distinct stock types should be made within a portfolio, despite their collective identity.

Flows during panics

American bonds are considered “safe havens” in times of market turmoil. They witness an increase in demand during panics, which drives up their prices. On the other hand, Indian assets generally fall under the bracket of “emerging markets”, and thus they tend to face the brunt of sell-offs. Consequently, possessing US bonds can act as a buffer in such situations, while investing in Indian bonds may not offer such protection.

Here’s how the US, Developed Markets and Emerging Market Bond funds have behaved through time.

Bubble assets

Digital assets, particularly collectibles, are known to experience boom-and-bust cycles. Although Bitcoin has been getting a lot of attention…

 

… the fact that CryptoKitties raised a total of $23 million in venture capital funding and people thought paying money to collect and breed virtual cats on the blockchain was a good idea should give investors some pause.

A similar dynamic exists in the art market as well, where investors try to spot emerging artists and bid up their works.

– Keeping it simple

If you are starting, you will do well to stick with big, liquid asset classes:

  1.     Indian Equities

o   Large-cap Index

o   Mid-cap fund

  1.     Given US firms’ vast international presence, the S&P 500 index gives ample coverage of many developed countries. Prospective Indian investors are not expected to gain much by investing in European, Frontier or other Emerging markets.
  2.     Bonds
  3.     Gold
  4. Real estate

If you are unsure of the relative proportions or you are just getting started, then an equal weight allocation between them is not such a bad idea.

For US stocks, stick to the cheapest S&P 500 index fund that you can find.

For Bonds, find a short-term bond fund that invests only in government or PSU bonds.

For Gold, go for the RBI issued Sovereign Gold Bonds that actually pays you 2.5% p.a. for owning gold.

For Real estate, see if exchange-traded REITs make sense.

-Risks to diversification

As investment opportunities expand, constructing a diversified portfolio becomes easier and more available. Nevertheless, financialization also impacts the behaviour of the assets in question.

Real-estate investments in the traditional world involve a whole different cast of players and transactions that can span months. On the contrary, REITs transacted on an exchange can be done within seconds. This has led to lower correlations being witnessed between real-estate and stocks. Nonetheless, with all these assets now available on the same platform, allowing investors to use one asset to acquire another, this has had the effect of raising their correlations. Thus financialization makes diversification simpler but reduces its potency at the same time.

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