Why asset allocation should be key to your financial planning

With the hike in interest rates over the last few months, the valuation of Indian stock markets came down, albeit with a bit of a lag compared to global peers.

Separately, global banking woes and a depreciation in the rupee drove Indian gold prices to a record high. The yellow metal was the best-performing asset class in FY23 with a one-year return of about 14%.

With yields remaining at high levels, the long-term maturity fixed-income instruments underperformed.

No single asset class outperformed or underperformed in all the fiscal years during the said period.

This highlights the importance of having a diversified portfolio and a suitable asset allocation. The last thing investors want to see is their investments depreciate when they actually need it.

Equity: long-term game

Domestic equity languished in fiscal 2023. “The Indian markets were affected by many factors including higher valuations, supply-chain constraints, hyperinflation, and the collapse of international banks due to mounting interest rates," said Vinod Nair, head of Research at Geojit Financial Services.

The market has been trading with a negative bias for a longer period (18 months) now. Nifty 50 delivered a return of negative 5% from 21 October 2021 to 31 March this year on a price return basis.

With this time correction, Nair believes that the market has factored in the negatives to an extent and the valuations moderated on a long-term basis.

“While the expected reversal in the monetary policy from a hawkish to a neutral tone in the coming quarters would be a positive trigger, one of the biggest perils is the slowdown in the economy not being completely factored in future earnings growth and its impact," according to Nair.

A closer look at the returns reveals that the small-cap segment (represented by 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 a higher risk in terms of volatility, outperformed all other asset classes in five of the 10 fiscal years. But in the years that it saw a correction, returns from this segment fell sharply, with mostly a double-digit decline in percentage terms.

Since small-caps have corrected in multiples compared to the broad market, Nair believes that the small-cap segment looks attractive on a long-term basis as it provides a better risk-reward ratio. Do note that this segment is only for those with high risk-taking ability.

For international equity, which acts as a good diversifier for a domestic equity-heavy portfolio, we looked at the S&P 500 Index data. The index delivered double-digit one-year returns (in rupee terms) in seven of the last 10 fiscal years. A meaningful portion of such return can be attributed to the depreciation of the rupee.

This rupee depreciation came to its rescue even in FY23 as well. Over the last 12 months, the S&P500 Index has declined nearly 10%, but the rupee depreciation of nearly 8% has helped the rupee-denominated index to be nearly flat. Talking about the poor performance of US equity, Sahil Kapoor, markets strategist and head- Products, DSP Mutual Fund, said “an uncertainty around growth and 475 basis points (bps) of rate hike by Fed has dragged US equity returns. Over the past years, the valuation of the index on a PE (price to earnings) basis has declined by 400bps."

The short-term outlook from here doesn’t look attractive either for US equity. “Going ahead, the volatility is likely to continue as growth in the US economy slows and corporate profitability resets to a lower level. Expect the index to remain in a broad range for the next few months," added Kapoor.

However, those investing for the long term must utilize the current correction opportunity through a SIP (systematic investment plan) route to tide over overall volatility, said Kapoor. Note that very few global funds are accepting fresh inflows currently.

Gold: higher volatility

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

Over the last 10 years, it has been the worst performer in four years and the best performer in three years. Further, the best years for gold were the worst for equity.

Again, it was the 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 the back of risk aversion created by the Russia-Ukraine war. Tailwinds to the price also included multi-year decade-high inflation in the developed world and pullback in risk assets. But headwinds in the form of a stronger dollar and higher interest rates during the rest of the year put downward pressure on gold," said Ghazal Jain, fund manager- Alternative Investments, Quantum AMC.

Going ahead, economic slowdown due to aggressive monetary policy tightening in the last fiscal year coming into play and the Federal Reserve being very close to the end of its tightening cycle will bode well for gold in the near future," believes Jain. Investment advisers suggest having a 5%-10% allocation to gold in the portfolio to withstand volatility.

Debt: mean reversion

The year saw the fastest clip of interest rate hikes by central banks across the world. As a result, yields on debt instruments spiked sharply. The rise in yields impacted the returns of long-tenure debt instruments, which are more prone to be volatile with yield movements.

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

“Debt markets are mean reverting. Thus, a bout of underperformance is usually followed by extraordinary gains as the yield oscillates through the rate cycles. We have seen yields spike in the last one year and this was reflected in the underperformance of the 10-year maturity category. Going ahead, as rates stabilize, and even fall, we should see the performance of the 10-year maturity fund make up for last year’s underperformance," said Sandeep Yadav, head - fixed Income, DSP Mutual Fund.

Having said that Yadav also highlights that investing in long-tenue papers is not for everyone. “The asset allocation between these two funds is dependent on investors’ risk profile. While I believe that the 10-year category could outperform the 91-day T-bill, but a more risk-conscious investor could prefer the latter," added Yadav.

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

Asset allocation is the key

The performance of each asset class depends on various factors that small retail investors may not keep track of all the time.

Thus, a diversified portfolio with suitable asset allocation is essential for an investor for a good financial planning. Asset allocation has been a time-tested method to contain losses in any market scenario as it balances risk and reward aspects of the portfolio. It is nothing but apportioning a portfolio’s assets across asset classes according to an individual’s goals, risk tolerance and investment horizon.

Talking about the importance of asset allocation, Renu Maheshwari, co-founder, Finscholarz Wealth Managers, said, “moving the assets into the winning asset class is a mistake most people make while managing their portfolios. Chasing a winning asset class results in sub-optimal returns on the portfolio. Appropriate asset allocation ensures that full advantage of the rally in that particular asset class comes to the portfolio."

She reiterated that asset allocation forms the basis of portfolio management and holistic financial planning.