Empirical studies reveal that markets tend to move in cycles and assets behave differently in different market cycles.
The outbreak of COVID-19 pandemic caused a synchronised meltdown of global markets. From the high of 12362 in January, the Nifty 50 plummeted to 7610 in March, a fall of a whopping 38 per cent! A pall of despondency shrouded the market. Off late, some recovery is discernible courtesy colossal liquidity infusion in conjunction with Unlock-I. The recovery may seem untenable as it reflects a dichotomy between the real economy and equity market.
Besides this, equity volatility may ratchet up due to sabre-rattling by China and India over border issues. At this juncture, it is pertinent to mix assets prudently in order to mitigate the downside risks. The mixing of assets is termed as Asset Allocation.
Empirical studies revealed that markets tend to move in cycles. Also, assets behave differently in different market cycles. For each asset, however, a mean-reverting stochastic process is discernible. This means that assets tend to diverge from and revert to their fair prices over time. This makes a compelling case for asset rotation.
Besides mitigating downside risks, asset rotation augments the probability of Alpha. A study attributes 91.50% of the portfolio performance to asset allocation. In this study, individual stock selection and market timing accounted for a paltry 7% of portfolio return.
Commensurate with your risk appetite and goal proximity, a portfolio is constructed by mixing heterogeneous assets like equity, debt, gold, REITs (Real Estate Investment Trust) , InvITs (Infrastructure Investment Trusts), etc. A diversified portfolio comprises of assets that exhibit low correlations. Besides construction, portfolio rebalancing is pivotal in order to achieve optimal outcomes. Rebalancing is warranted if there is a portfolio drift from the threshold.
Ironically, behavioral biases distort investment decisions. Our ingrained gut instincts of fear and greed helped us become evolutionary winners. However, survival instincts distort investment decisions. Warren Buffet said, “Be fearful when others are greedy and be greedy when others are fearful.” Investors seldom follow this cardinal tenet and burn fingers by taking the contrary position. They tend to resort to panic selling when markets become choppy because we fear losses more than we value gains. Such an irrational conservatism entails huge opportunity cost due to potential investment gains foregone. Ostensibly, it looks difficult to fix the innate biases as they are hard-wired into us.
To fix this asymmetrical condition, it will be prudent to employ processes that dynamically recalibrates asset allocation while keeping emotions/sentiments at bay. The calibration triggers emanate from a quantitative model.
The model helps in efficiently capturing the upside while simultaneously protecting the downside. We suggest Dynamic Asset Allocation or Balanced Advantage Funds that work on the aforementioned principle. Besides Equity and Debt, we suggest exposure in Gold. Domestic momentum in Gold is expected to be buttressed by a flagging growth, low-interest rates, high liquidity and depreciation of rupee against the greenback. At a time when the equity market is in turmoil due to Covid-19 pandemic, Gold retains its lustre as a store of value.
(By Dhritiman Chakraborty AVP – Research, Bajaj Capital: The views are personal)