Why asset allocation is important?

Equities are generally considered the best performing asset class for the long-term horizon. Instead of recommending to put the entire investment corpus in this best-performing asset class, there are many investment advisors who insist on having an asset allocation-based investment plan where funds are split across various asset classes such as equities, gold, real estate, and fixed income instrument, etc.

Does by recommending allocation of funds in lower return generating assets, the advisors are doing a disservice to their clients?

Let’s find out

Historical performance of Indian equities

NIFTY50 TRI generated an annualized return of 17.09% in the last 20 years (From 1/11/2001 to 31/10/2021). Although, this figure looks quite ordinary in the context of the last 12-18 months returns achieved in Indian markets but it is not. Generating such kinds of returns for a long period of 20 years is quite commendable. At this rate of annual return, Rs 1 crore will turn into more than 23 crores in a 20-year period. And this is just a large-cap index. If we consider Midcap and small-cap indices the returns will be even higher.

One may argue that this approach of considering point-to-point return is flawed. If we change the start and end date, there can be significant variation in returns even for a 20-year time horizon. For example, for a 20-year period (from 01/04/2000 to 31/03/2020), annualized returns will only be 10.54%. At this rate of annual return, Rs 1 crore will turn into 7.4 crores in a 20-year period. Just 1/3rd of the value compared to the earlier example. However, on an absolute basis, this is still quite substantial and much better than other options such as bank FDs, PPF, Bonds, etc.

Indeed, a change in start and end date does change the return calculations significantly. So a better approach is to consider rolling returns. To get a large set of data for analysis, let us consider 15-year rolling returns.

For all 15-year periods from 30th June 1999 till 30th November 2021, the return distribution is as follows:

	Average	Median	Max	Min	Std. Dev.
Nifty 50 TRI	14.91	14.59	19.34	10.61	2.09

If one is willing to stick for the long term, the minimum returns generated for a 15-year holding period is 10.61%. In this scenario, the investment value will be more than 4.5x. Not bad at all.

But what about the intermediate volatility? Yes, these returns are achieved with significant drawdowns on the way. This poses the below risks:

• Investor may not have knowledge and behavioural discipline to ride through the volatility and may end up selling in panic when prices are down.

• Investor may need money for his goals and is forced to sell at an unfavourable time.

• If investor is using leverage for such investments, during severe drawdowns he may not be able to fund the margin calls and broker might liquidate his holdings.

• Within overall equity allocation, Investor may switch funds and stocks too frequently, resulting in significant portfolio underperformance vis-à-vis index. Transaction costs and taxes further reduces returns in such scenario.

If an investor is exposed to such risk it makes sense to invest in other asset classes also. But what about those investors who are not exposed to these risks? For instance, what should be the recommendation for an investor who

• is well versed with equity markets

• has the behavioural discipline to ride through the intermediate volatility

• avoids frequent switching and can stick with same funds

• has long-term goals such as retirement etc

• does not use any leverage

Should such an investor allocate 100% to equity?

Based on the past track record of Indian equity markets, the answer seems to be yes. We can also analyze data of other equity markets to further substantiate this conclusion.

The Untied State of America

US markets have a very long history, going back to more than 100 years. A great amount of historical performance data is available. Let us consider three main US indices; Nasdaq, S&P 500, and DJIA.

US markets have performed really well for the last 50-100 years. But we can see there are intermediate periods of significant underperformance running up to even 20-25 years.

Dow Jones

• In Nov 1916, DJIA was at 105. After a good 26 years in July 1942. it was at same level.

• In Sept 1929, the DJIA reached a record high of 381.2. after 15 years in 1944 it closed at 152.3, 60% lower. It crossed the 1929 levels only in 1954. After a good 25 years.

• In Dec 1965, DJIA was at 969. After 17 years, in Oct 1982 also it was at same level.

• May 1966 reached high of 995. After 16 years in 1982 it was at same level.

• Even in recent time, there have been instances of underperformance. For instance, DJIA was 11497 in Dec 1999. After 11 years in Dec 2010, it was at same level.

• In DJIA, history there are many 15-25 years periods when index did not yield any capital gains. Dividend yields were mostly in line with bond yields. So effectively there was no outperformance by equities even in very long periods of 15-25 years.

S&P 500:

• In Sept 1929, the S&P 500 reached a record high of 30.16. It crossed the 1929 levels only in 1954. After a good 25 years

• In Nov 1968, the S&P 500 was at 108.37. After 14 years, in July 1982, it was at same level.

• In August 2000, S&5 500 was at 1517.68, After 13 years, in Match 2013, it was at same level.

Nasdaq:

• In Jun 1972, Nasdaq composite was at 862.82. After 19 years, in Feb 1991, it was at same level.

• In Feb 2000, Nasdaq composite was at 7,650.91. It reclaimed this level only in Nov 2017, after 17 years.

The longevity and severity of underperformance for some of the periods in US markets is much more than what Indian markets have ever witnessed.

What about other global markets?

Let consider historical performance for other leading economies such as France, Japan, Hong Kong, and Germany.

France

• In Sept 2000, CAC 40 was at 6703.36. It crossed this level only in August this year, after 21 years.

Japan

• Japan’s Nikkei 225 has the most extreme example of underperformance. In Feb 1990, Nikkei 225 was at 37,288.14. Even after 31 years, it has not reached these levels.

Hong Kong

• In Nov 2007, Hang Seng Composite was at 30,468.34. Even after 14 years, on Nov 30, 2021, it is at 23,475.26. Down by 23% in 14 years.

Most other global indices have also seen long periods of negative or nil returns.

• Shanghai Composite index is still 40% down vis-à-vis peak achieved in Oct 2007.

• UK’s FTSE 100 Index is at similar level currently as that of observed in dot com peak in Dec 1999.

• Australia’s ASX100 is just 7% higher currently than peak achieved in Oct 2007.

In both US and other global markets, long periods of equity underperformance have been observed. It is quite possible that in the future even longer and severe underperformance is exhibited by equity markets.

Equities – high probability but no certainty

The US is the largest economy. In addition to the Indian markets, most advisors also consider US markets to analyze historical equity performance. Generally, other global markets are not given adequate attention. A cursory look at the performance of some of the prominent global indices, it is quite evident that even with very long holding periods of 15-20 years, there is no certainty that equity will outperform. Even in the US market, several long periods of underperformance have been observed.

This risk further increases when an initial investment is made when markets are overvalued. Any lumpsum investment made in 1999/2000 at peak of dot-com mania or in 2007/2008 at peak of the subprime crisis has underperformed for long periods of time. Some indices have still not been able to reclaim the levels achieved in 1999/2000.

Markets discount the future improvement or deterioration of underlying business performances. Due to which markets can remain out of step from underlying economic realities for significant periods of time. This makes the timing of entry and exit from equities extremely difficult. Even though there have been some longer-term periods of underperformance in equities across most markets, there is no denying that most of the time equities have generated healthy returns.

In equity investments, we cannot be certain and can only think in probabilistic terms. that is if equities are held for the long term, it offers a high probability of good returns. The investor must keep in mind that this probability is not 100%. But it is good enough to allocate some funds in equities to capture the possible upside. How much one should keep in equities will depend on the risk appetite of any particular investor. Risk appetite does not only mean daily fluctuations. It also means, although small but, a non-zero probability of permanent loss of capital even after holding for 10-20 years.

Asset Allocation

The best way to solve this conundrum is to allocate funds to various asset classes such as equities, gold, real estate, fixed income instruments, etc. based on the risk profile of the customer. An asset allocation approach has many advantages:

• Investors will not be too dependent on the performance of a specific asset class.

• As various asset classes are not fully correlated with each other, the volatility of portfolio will also be reduced. Lower overall portfolio fluctuations make it easier for investors to hold on to riskier assets in portfolio for long periods of time. Resulting in better portfolio performance in long run.

• % allocation between different asset classes can tweaked to align with the risk profile of the individual investors.

• As the investors have all asset classes in their portfolio, the urge for frequent churning is also reduced to some extent.

• This eliminates need for market timing for a superior risk adjusted portfolio performance.

• Customised asset mix can be designed for each goal, depending on the criticality and time horizon. Makes goal based planning more efficient and effective.

• Only periodic rebalancing is required to be done to stay on course. This eliminates large scale changes in portfolio composition on frequent basis. Lower tax cost and more tax efficient approach.