Nothing proves the caveat “past performance is not an indicator of future returns" more than a performance table for 10 asset classes for the decade ending 2019 (see graph), where each colour represents an asset. The randomness of short-term returns that gives the “quilt" effect shows the absence of any pattern that will help win the short-term game of selecting the asset that will be the winner in the next year. With the exception of gold, which was the top performer in 2010 and 2011 on fears of inflation, there was a different asset on top in each of the next eight calendar years. Each year, there was also a new combination of top-quartile performers, with no asset making the cut more than two years in a row, except for large-cap stocks.
We also catch the volatility in asset classes. Gold slid to the bottom of the table in the three years following its run at the top and remained a laggard till it again zoomed to the top quartile in the last two years. In some asset classes, such as real estate, the real returns to the investors, after deducting actual and opportunity costs, is much lower than what is indicated by the price movements.
Here are a few takeaways from the performance table.
Focus on long term
There are no advantages to looking at short-term returns of individual asset classes because they have no predictive properties. Instead, focus on your goals and needs—long-term or short-term—and build a portfolio aligned to them. “The asset allocation takes shape according to the client’s goals. It would be in separate buckets depending upon the tenor of the goals," said Kalpesh Ashar, founder, Full Circle Financial Planners and Advisors.
Only those asset classes that are relevant to your goals should be included in the portfolio.
Asset allocation shows where you sit on the risk spectrum in relation to your investment horizon. This helps you take the emotions out of investment decisions and stay with the plan. “The right asset allocation matches the return expectation to the actual risk profile," said Priya Sunder, director and co-founder of PeakAlpha Investments. “When this is done, there is no need to sweat over short-term market movements," added Ashar.
Periodic rebalancing should be built into the plan so that the allocation remains relevant. “The combination of setting the target allocation and the discipline of rebalancing periodically will help cancel out market noise," said Sunder.
While the annual returns can give you an idea of over-valuations or under-valuations, making decisions in expectation of a reversion to mean can’t be timed. For example, the large-cap segment is seen as over-valued at current levels but it’s still touching new highs. Rebalancing the portfolio if the allocation to large-caps has gone up significantly will allow you to book profits as well as benefit you from an upturn in other segments of your portfolio whose allocation has dipped.
“When you have a target allocation to focus on, it keeps an investor from being swayed by greed or fear," said Sunder.
Diversification is key
A diversified portfolio is never the one with the highest returns. An investor holding a diversified portfolio is likely to be unhappy with an asset class that did poorly in a given year and dragged down the portfolio’s returns. But the same asset class may be the top performer the following year, shoring up the portfolio’s returns. Over time, you will see the benefit of diversification and how it smoothens out the ride, especially when you have greater exposure to asset classes like mid- and small-cap stocks that tend to see feast or famine situations and can do with some companions to tame short-term volatility in returns. “Asset allocation helps strike the right balance between high risk-high return investments and conservative ones in a portfolio," said Sunder.
Consider active funds
Actively-managed funds have had a better experience on risk-adjusted returns as compared to the indices in spaces such as mid- and small-caps, or tactical investment in gilt funds. After asset allocation, decide whether the cost of an actively-managed fund is justified or a passive strategy works better.
When you are saving for the long term, you are braving multiple market cycles. To let reallocation be driven by your expectations of next year’s best performer would shift the focus from your goals to the markets. For your core investments, let asset allocation guide the way.
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