Remember the day when you first rode the bicycle? After a brief ride, you fell. You scratched a knee or hurt the ankle. That’s when you first realized the importance of maintaining ‘balance’. Unless you have an even distribution of weight, we cannot remain upright and steady. Yet, when it comes to investments, balance is mostly forgotten. In the mad rush for growth and gain, balance takes a bad seat. All it takes to rock our investment bicycle is some volatility. Before you know, you are staring at the ground. Scary stories aside, achieving balance in your investment portfolio is easy. It is unfortunate that people do not look at it. By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can easily protect against significant losses. Read on to know more.
Historically speaking, the returns of the four major asset categories i.e. stocks, bonds, gold, and cash, have not moved up and down at the same time. When the two move down, one moves up. This is because market conditions that cause one asset category to perform often cause another asset category to have average or even give poor returns. So, by investing in more than one asset category, you can easily reduce the risk of losing money. Come to think of it, such a simple approach will lead to your portfolio’s overall investment returns giving you a smoother ride. When one asset category’s investment return falls, you’ll be able to counteract your losses in that asset category with better investment returns in another asset category or categories.
If you look at the last 15-20 years, you will see how the debt asset category has mostly given stable returns. Equity is a rock-star; on some years it does very well while in some others it gives negative returns. Gold doesn’t give stupendous returns in most years, but when the market is gripped by fear, look at gold! Cash doesn’t itself generate returns unless invested, but it is a strategic tool to increase exposure or decrease exposure. How to use the 4 assets in the optimal proportion? That is what Asset Allocation (AA) teaches you. It is important to know this Double-A (AA) because it has a major impact on whether you will meet your financial goal, especially if that goal is 10-20 years away.
Balancing your portfolio does not mean removing risk from your portfolio. If you don’t include some risk in your portfolio, your investments may not earn a large enough return. Without such a return, you will find it very hard to meet your defined goals. So, balancing your portfolio means striking the right balance between risky assets and less risky ones. For example, if you are saving for a long-term goal, such as retirement, include at least some stock or stock mutual funds in your portfolio. As the goal is achieved, start using more stable assets to lock in those gains. This is just an example.
The main point about any asset allocation or balance in your investment portfolio is to give better risk-adjusted returns. Nobody knows what will happen today or tomorrow. So, the plans are educated estimates and present the best approach to deal with such situations. Certain investment products do automatic asset allocation by using the hybrid approach or lifecycle approach. In a standard hybrid approach, the asset allocation matrix is fixed. There is little dynamics involved. As a result, money is invested and returns gained based on fixed asset allocation. The lifecycle fund approach calls for a slightly pragmatic approach. In this case, the investment corpus automatically shifts towards a more conservative mix of investments as it approaches a particular year in the future (target date). This protects gains and lets you lock them, instead of witnessing unfortunate situations where the entire corpus may lose a bit of value a day before your goal date comes.
Let your money live in harmony. Balance the investments and witness the magic.
(By Anil Rego, Founder and CEO, Right Horizons)