In these unprecedented times, investors, seasoned or amateur, are struggling to do their job well. There are many questions preoccupying market volatility right now, namely, when will markets bottom, when will inflation come down, when will the interest rate cycle peak, and when will the will the war end? There are no easy answers to these questions and this further adds to the dilemma for market participants. Although all of these factors affect us directly, we have absolutely no control over any of them.
The only solution is to focus on the things we have control over, like sticking to your investment philosophy, asset allocation and discipline. Diversification is an age-old strategy that works well through market cycles because it reduces the portfolio’s sensitivity to market risk. So, while portfolio creation is mandatory, an uncorrelated or less correlated asset would help achieve better diversification. This reduces drawdowns at the portfolio level while acting as a hedge against volatility.
The asset allocation model not only involves having multiple asset classes in the portfolio, but even one might consider having subclasses within an asset. For example, in equity asset allocation, one might have different proportions towards large, mid and small caps which at times experience uncorrelated returns. This was evident in recent history when these indices differed in their behavior. Of course, during secular bull and bear markets, the divergence might not be different as the overall asset moves in the same direction. For example, in the last calendar year 2021, the Sensex recorded a return of 22% while that of the mid and small caps are 39% and 63% respectively. Similarly, in 2011, returns were -25%, -34% and -43% respectively for the large, mid and small cap indices. Average returns over the past 10 years represent gold at 3%, bond index at 9%, Sensex at 14%, mid cap index at 17% and small cap index at 18%. Although the long-term returns of equities as an asset class trump most other assets, the investor experience would be less transparent due to volatility. There has not been a case in the past 10 years where all asset classes generated negative returns in a year, proving once again that asset allocation and diversification help investors weather periods of volatility with relative ease. Another easier and more convenient way to reduce stock market volatility is to ladder investments. Investors could opt for systematic investment plans, commonly known as SIPs, which could be carried out over a defined period on a definite date and at a fixed amount at each interval. This makes it possible to spread out the cost of acquisition, making it possible to acquire a greater number of units. Of course, this is a convenient method for salaried classes where there is a fixed interval paycheck, but freelancers or business people could opt for a systematic transfer plan, STP, where one could park the lump money in a liquid or ultra-short. term funds to move into shares at regular intervals, daily, weekly, monthly, etc., so that a staggered amount is exposed to the equity market even though the tied up money is inflation protected.
If the fund manager believes the market is overvalued, the amount in the lower end of the range is invested and the upper end of the range is invested if the market is considered undervalued. This iteration would further optimize the rupee cost averaging that staggered investments are meant to do. However, too many modifications wouldn’t make a huge difference in the long run. However, the proportion of allocation to each of these assets would enhance returns for an investor and should be in line with risk appetite.
(The author is co-founder of “Wealocity”, a wealth management company and can be contacted at [email protected])