|By Rohit Bajoria
EQUITIES – You can’t do without
Secrets of the Smart Investor
The market carnage in recent months has caused immense panic world over.
Retail investors are trapped in the market's 'maze'. They entered the markets, assuming that the markets will scale new heights soon. However, with markets crumbling, most have landed up getting entangled, with no exit in sight!
The pin up boy of the Indian markets Mr. Rakesh Jhunjhunwala who has made a fortune by investing in the stock market from an initial amount of $100, he has made $100 million in just over two decades says, "Markets are like women; always commanding, mysterious, unpredictable and volatile."
So, let’s begin by introspecting and learning from this mayhem.
Investments primarily rest on 3 pillars of returns, risk and liquidity. The primary objective in an investor’s investment portfolio is wealth creation. (Fig 1)
In a large study performed on the investments within many pension and endowment funds (organizations with a required distribution flow, much like a family), it proved that over 90% of the investment return of a portfolio comes from asset allocation. Asset allocation is the single most contributing factor to the long-term performance of an investment portfolio. (Fig 2)
So, what exactly is asset allocation? Asset allocation is dividing investments in different classes keeping in mind the risk profile, time horizon and cash flows or liquidity requirements. Each asset class has different levels of return and risk, so each will behave differently over time. For instance, while one asset category increases in value, another may be decreasing or not increasing as much.
Some critics see this balance as a settlement for mediocrity, but for most investors it's the best protection against major loss should things ever go amiss in one investment class or sub-class. Here is an example of what assets a portfolio can include. (Fig 3 )
The purpose of asset allocation and portfolio guidelines is to clearly state the investment approach, define performance objectives and to control risk. Asset class and portfolio guidelines should be subject to ongoing review. Past performance, investment resources, new financial instruments, or a change in the risk tolerance can be among the reasons for a portfolio review.
Despite many new groundbreaking studies showing the critical role asset allocation plays in investors' portfolio returns, it is painfully clear many investors caught up in the equity boom were over-allocated to equity investments, in particular, telecom, technology and media companies, and paid a heavy price when equity returns soured.
Many investors are responding to these heavy losses by selling their stock holdings or redeeming their equity mutual funds or switching to and over-weighting in bond funds. As we deal with these issues, it is an excellent time to discuss how proper asset allocation (yes, including the very equity investments they may be selling right now) can go a long way in preventing the huge return gyrationsgy works so well because cash, bonds and domestic stocks have low return correlations with each other, meaning the returns on each asset class does not depend too much on the other; if one asset class does well, often another does poorly, so over time each asset class's return balances the others out, for a smoother and higher returns over longer time periods. Low correlated assets were (and still are) the key to having an effective asset allocation strategy.
The first question we will be asking is, are equities necessary for an investment portfolio?
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