Is Your Risk Well Mitigated ?

Sadashiv Phene
Independent Financial Advisor

The financial markets offer exciting investment opportunities to investors across the asset classes. Such asset classes include equity, debt, gold, real estate, etc. Some investors might feel comfortable investing in a single asset class as they understand that asset class better. However, investing in a single asset class exposes the investors to cyclical as well as concentration risks. As such, curating a diversified portfolio plays a vital role in ensuring long term wealth creation, as it helps mitigate the investment risks to a certain extent. The proportion of different asset classes in the investment portfolio is referred to as asset allocation. Deciding the optimal asset allocation and then sticking to it helps the investors adopt a systematic approach towards financial goals by balancing the risk profile and investment horizon.

Different asset classes tend to react to different economic developments. For example, the lowering of the interest rates in the economy may be expected to fuel the economic growth and hence a positive for the equity markets. On the other hand, this might be deemed detrimental for the debt markets, and the investors may be able to generate lower returns from debt funds. As per the historical performance of different asset classes, no single asset class has been a winner for the investors across the years. The returns from different asset classes tend to be cyclical, and staying invested across asset classes helps the investors to benefit from such cycles.

Different research studies indicate that the investors tend to exhibit emotional investing and generally buy when the markets are rising on the back of FOMO (Fear Of Missing Out) syndrome. Similarly, when the markets are falling, the investors tend to cash out their investments, instead of increasing their investment exposure at lower valuations. Rationally, one must do exactly the opposite, i.e., buying when the markets are falling and selling to book profits when the markets are rising. Staying committed towards asset allocation also helps the investors to mitigate the investment risk to a certain extent, as the investors adopt a logical investing approach for long term wealth creation.

While one generally stays concerned about timing the market for generating better returns, asset allocation continues to remain as the single most important deciding factor in determining the investment returns. This is due to the fact that a prudent asset allocation strategy insists on increasing the allocations in the asset classes with relatively inexpensive valuations and booking the profits from the investments at higher valuations. Focusing on the relative valuations enables the investors to add more undervalued investments and, therefore, the investment portfolio stays equipped with the potential of higher returns.

Since different asset classes are also associated with varied risk-return trade-offs, the investors can align their portfolio to suit their risk profile with the help of asset allocation. For example, aggressive investors may prefer to have a higher proportion of equity investments in their portfolio. On the other hand, a conservative investor may wish for stability in returns and lower volatility for the portfolio and thus carry a higher debt allocation and lower equity exposure. As such, asset allocation allows investors to manage the investment risks within the tolerance range.

Managing the asset allocation with periodic rebalancing may seem easier said than done for the investors, as regular monitoring of the valuations of different asset classes is not an easy task in the dynamic markets. As such, maintaining the optimal asset allocation through mutual funds is the best option for investors. Mutual funds allow professional fund management for the money invested and adopt scientific valuation models to determine the relative valuations across the asset classes. Asset allocation mutual funds, a specified category of mutual fund schemes, help to address the need to re-balance various asset classes as per market attractiveness. Such mutual funds adopt the 'buy low, sell high' approach, wherein they adopt tested valuation models to buy the investments across asset classes at a lower valuation and booking the profits at higher levels. As such, it eliminates the emotional bias in the investment journey and instead, allows the investors to systematically maintain the optimal asset allocation that best suits their risk appetite.

When the markets are volatile, continuing with the systematic asset allocation can help the investors steer through the market ups and downs seamlessly, thus sustaining the market momentum in their favour and helping them to participate in the cyclical rallies of different asset classes. As such, the investors must stay diversified across asset classes, with optimal asset allocation in the pursuit of long term wealth creation.

The writer is a Independent Financial Advisor