The Investor's Guide to Asset Allocation Strategy in Volatile Markets
Equity market volatility tends to be inversely correlated with the time horizon. In the short term, market volatility can be high, as evidenced by the Nifty, which recorded highest and minimum returns of +92% and -53% over a rolling one-year period from 1995 to 2022. Conversely, over a 10-year perspective, the greatest and minimum returns moderate to +20% and +4%, respectively. Thus, asset allocation should be strategically designed to accommodate market volatility.
The asset allocation strategy should consider several factors:
- Investment Goals: These can be both long-term and short-term.
- Horizon of Investment: This is the period an investor is willing to maintain their portfolio.
- Risk Appetite: The capacity of investors to take on financial risk in anticipation of potentially making a profit.
- Liquidity Requirement: The need for how quickly one wants to be able to convert their investments into cash.
Approaches in a Volatile Market:
- Stay committed to the market and resist the impulse to panic-sell.
- Adhere firmly to your predefined asset allocation strategy.
- Consider opportunistically increasing your market exposure when significant downturns occur.
- Rebalance your portfolio as necessary to maintain your target asset allocation.
Understanding Risks and Mitigating Them through Asset Allocation
1. Inflation Risk: Inflation can erode the real returns of a portfolio. Constructing an inflation-resistant portfolio is essential for generating significant profits over the long term. Targeting returns that outpace inflation by a substantial margin is advisable.
2. Liquidity Risk: Liquidity risk concerns the ease of selling investments without impacting their price. Certain assets, such as real estate, may exhibit lower liquidity. Integrating these with more liquid investments can help mitigate this risk.
3. Concentration Risk: This risk arises from excessive investment in a single area, be it a particular investment, industry, or geographic region. Diversification across various industries, asset types, and regions can minimize this risk, enhancing portfolio resilience against downturns in any specific sector.
A certain level of uniformity in returns can be achieved through thoughtful asset allocation based on your investment horizon. The interaction between different asset classes, in the long run, offer balanced returns.
Historically, equity-focused investments have offered higher returns compared to more conservative assets. An asset mix that includes a significant allocation to equities can, over a period longer than five years, yield an average return with a balanced risk profile. For example, allocating a majority to equities with a smaller proportion in less volatile assets could be a practical approach for those seeking to manage volatility while aiming for substantial returns over time.
Ultimately, a well-considered asset allocation that dynamically adjusts to changing market conditions and personal financial goals can help investors navigate volatility effectively and achieve their investment objectives.