Asset allocation is a strategy to mitigate risks
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Asset allocation is integral to financial planning. However, investors are often unsure what it means. Let’s understand why asset allocation enables you to manage the risk of losing money rather than increasing returns.
Suppose you have a target of ₹1 crore to meet your child’s education after 15 years and you can save ₹25,000 every month for this purpose. Then, in this case, you will need an 8.3% return annually. This return will define if you need to take a high or low risk. Also, while you might need to take risks, you might not have the loss tolerance defined by the maximum amount of uncertainty one can accept.
How much risk can you take?
You might feel ‘okay’ with a 10% market correction as it only takes a 11% gain (from those levels) to recoup your total losses. But a loss of 20%, for example, is ‘harder’, since it will require a 25% gain to break even. By the same logic, a 40% loss might seem ‘overwhelming’ as it takes a 67% gain to recover this loss, and a 50% loss even more so, as it requires a whopping 100% gain to recoup your losses.
Most investors start getting nervous when the market tanks beyond 30% and panic when it tanks beyond 40%. So, the big question is —What’s the drawdown you can handle realistically? So, there is a need to create a maximum loss plan.
What can investors do?
Since 2000, Indian equity markets witnessed more than a 30% correction in a calendar year on six occasions. In 2000 and 2001, equity markets were down even more—by 43% and 42%, respectively, while in 2008, they were down by 65%.
So, let’s assume the probable maximum loss is 40% in a year on most occasions. So, what’s the maximum loss you are willing to take in your portfolio. Let’s say it is 20%. Then, divide your maximum portfolio loss by the maximum stock market loss that could probably happen. In this case, it would work out to 0.20 divided by 0.40 = 0.50 or 50%! So, your target equity allocation should be roughly 50%.
Also, it is very important to determine your equity sub-components. Investing in midcap and smallcap funds, for instance, carries higher risk and could therefore have the potential to see a more significant portfolio drawdown.
Similarly, investing in just a few stocks or relying too heavily on employee stock options (ESOPs) increases the non-diversification threat.
Valuation of equity and debt changes frequently, and asset allocation needs to change to reflect this. So, for instance, in 50:50 equity: debt allocation, if equity appreciates by 30% in a year and the debt portfolio appreciates by 6%, the equity: debt mix will get modified to 55:45. To ensure the portfolio doesn’t have a more-than-palatable potential drawdown, reduce the equity portion to 50% levels. Similarly, in a core-satellite portfolio structure, you need to protect the core from the vagaries of the satellite portfolio.
Return maximization
After losing 50% in a year, it would take a 100% gain to return to the same levels. And staying invested can make the process faster. How is that? Often, investors lose out on market gains by trying to time the market.
A study by Motilal Oswal shows that more than 50% of the best 30 days in the last 30 years happened during bear markets. And exiting it could mean losing out on the opportunity. In the above instance, if the market were to gain 10% every year after a 50% correction, it would take seven years to recoup all your losses. Why not 10 years? Thank the power of compounding!
During the bull run of 2002-2008, Nifty 50 was up by nearly six times—from 1,100 in January 2002 to 6,300 in January 2008, a CAGR of 33% per annum. However, it went through seven double-digit percentage falls, two as sharp as 30% during this period. Similarly, from May 2014 till August 2021, Nifty 50 grew 2.5 times, at a CAGR of 13%. But, in intermittent times, there were five drawbacks of over 10%, two of which were more than 20%.
So, stay put as good returns will eventually follow. The best investors focus on risk management that fits their long-term goals.
Anup Bansal is chief business officer, Scripbox.