In July 2023, the Nifty and Sensex went past their previous highs to new all-time high levels. Along with the large-cap indices, the mid-cap and small-cap indices also hit all-time highs. As an investor, if you have been investing through SIP for the last few years, you will be happy to see your portfolio giving excellent returns.
While you may celebrate the portfolio returns and continue investing through SIP, you should not get carried away with over-exposure to equities. With stock markets at all-time highs, it is a good time to evaluate your asset allocation.
Let us understand what asset allocation is, the role of different asset classes in a portfolio, why to avoid equity over-exposure at all-time highs, and always follow asset allocation.
What is asset allocation and its importance?
Asset allocation is an investment strategy that involves allocating the portfolio money to different asset classes, such as domestic equity, fixed income, gold, international equity, real estate, etc. The objective is to diversify the investment portfolio, reduce the risk, and earn better risk-adjusted returns.
Different asset classes move in different directions each year. Usually, there is a low to no correlation between most asset classes. These asset classes may take turns to outperform each other depending on various factors, such as the economic cycle, geopolitics, inflation, interest rates, etc. Hence, your portfolio should have exposure to different asset classes so that irrespective of which asset class does well, your portfolio benefits.
Performance of various asset classes in the last 10 calendar years
The above chart shows how different asset classes have outperformed in the last 10 calendar years. Hence, you need to follow asset allocation.
Role of asset classes in an investment portfolio
Each asset class has a role to play in an investment portfolio:
Domestic equity: It has the potential to give high returns in the long run and create wealth for you. In the past, domestic equity has given good returns and continues to do so, with stock markets currently at all-time highs. However, equities come with high volatility and risk.
Fixed income: It has the potential to generate steady regular returns. It has low volatility compared to equity. When equities fall sharply, the fixed income cushions the impact on the overall portfolio.
Gold: It acts as a hedge against inflation and a safe haven during war, economic uncertainty, etc. During Covid uncertainty, gold did well. Even during 2022, when the Russia-Ukraine war intensified, gold gave good returns.
Real estate: It can earn regular returns in the form of rent and has the potential to generate capital gains in the long run. It has low volatility compared to equity.
International equity: It has the potential to give high returns in the long run, just like domestic equity. It can provide a hedge against country-specific risks. Indians investing in international equity (US markets) can earn additional returns from the steady depreciation of the Indian Rupee against the US Dollar.
Factors that determine asset allocation
An individual’s asset allocation may depend on factors like:
Individual’s risk profile: An aggressive investor will have higher equity allocation. A conservative investor will have a higher fixed-income allocation. An investor with a moderate risk profile will have a balance of equity and fixed-income.
Age: Usually, as an individual ages, the equity allocation goes down, and the fixed-income allocation goes up.
Time remaining for a financial goal: As the date for the financial goal nears, the equity allocation goes down, and the fixed income allocation goes up.
Financial liabilities and responsibilities: When an individual takes a bigger loan like a home loan, it may reduce their appetite for high-risk investments like equity. The same may happen when an individual’s responsibilities increase (for example, an individual gets married or becomes a parent).
Why should you always follow asset allocation when markets are at all-time-highs?
When markets are at all-time highs, there is a lot of euphoria. Some existing investors may increase their equity allocation, and new investors may invest in equity. But, there is a bear market after every bull market, and vice versa. If you have over-exposure to equities when the market is at all-time highs, you may face high losses if there is a sudden big fall in the market due to any reason.
For example, till 2007, there was a big bull market. There was euphoria. Even though valuations were expensive, some people had over-exposure to equities. What followed in 2008 was a big stock market crash due to the subprime crisis. As a result, people who had over-exposure to equities had to face significant losses. Some people panicked and sold at lower levels and booked losses.
Something similar happened in 2020 when the Covid pandemic struck. There was a big market crash leaving overexposed people with heavy losses. Hence, you should always follow asset allocation. When markets are at all-time highs, you should stay calm and continue with your existing SIP investments. If your equity proportion has risen due to a rally in the stock markets, you should review your portfolio regularly and rebalance it. You may rebalance by selling equities and investing the proceeds in other asset classes, or you may contribute incremental money to other asset classes to maintain asset allocation.
Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.
