Harry Max Markowitz, an American economist, and Nobel Laureate, said, “Diversification is the only free lunch” in investing.
During the 1980s, investors noticed the Japanese stock market had been performing well for decades due to its rapid economic development.
Countries like Hong Kong, Singapore, Korea, and Taiwan successfully adopted similar industrialization strategies and were coined as emerging markets.
Investment portfolios in the US and Europe were exposed to the struggles of their domestic manufacturing industries as globalisation accelerated, triggering an asset allocation shift from developed markets to emerging market equities.
The developing world has enjoyed rapid economic progress in the last few decades, and the emerging market term no longer captures the complete picture. Investors need to embrace a more nuanced view.
Diversification across geographies has proved effective in generating returns while mitigating risk in the past.
However, in the year 2020, when the markets crashed due to the recessionary fears caused by the COVID-19 pandemic, diversification across equities globally disappeared when needed the most.
As globalisation progressed, the economies became intricate, increasing the correlation between the global equity markets.
Diversifying portfolios across asset classes should preserve them from the vulnerability of extreme price movements. While economically-correlated assets suffer simultaneously during recessions, asset classes that are less sensitive reduce the risk to the portfolio.
Investors can typically use these assets to hedge their portfolios against bad times. Domestic government bonds can protect investors against the risks of deflation.
Holding cash dampens portfolio volatility and allows investors to buy at lower prices during market crashes. Gold typically performs well when the threat of inflation persists for a longer period or during political uncertainties.
Investors can derive from Exhibit 1 that no asset class consistently outperforms others in the short term, and the 10-year CAGR construes investing over a longer horizon will compound wealth.
We have back-tested and noticed that even a vanilla hybrid fund (60% in equities & 40% in debt) could optimise return and mitigate volatility for the risk taken. The grounds for that are that asset classes, barring a few exceptions, tend to be influenced inconsistently by macroeconomic occurrences, yielding better risk-return trade-offs.
The appropriate proportion of capital allocated to assets is crucial in building an optimal portfolio. If not, investors are exposed to unwarranted risk; for example, if an investor were to invest 100% of the capital in the index, they would be exposed to undue volatility.
However, tactical asset allocation will integrate capital market expectations with investors’ desired level of risk and constraints, focusing on the long term as exposures are targeted based on the quantifiable systemic risk of each asset class and generating maximum returns for the risk an investor can hold.
Technological advances are disrupting the economy and markets, creating a more granular analysis of a diversified portfolio of alternative assets that can generate returns comparable to those of traditional risky investments: equities and corporate bonds.
Diversification across asset classes can increase the certainty of generating higher returns over the long term while mitigating risk to the desired level.
Millennials are tech-savvy when it comes to investing, and having access to information from a wide range of sources. However, we suggest refraining from investing directly in equity unless they have a thorough understanding of the business.
If not, consult a financial advisor or the simplest and most effective strategy to follow is the systematic investment plan in two or three selective mutual funds.
Millennials often look at real estate with emotions and plan on buying houses earlier in their lives.
However, we suggest prioritising and allocating more towards equities in the initial stages and eventually increasing allocation to real estate, debt, and gold since equities will provide higher returns relative to other asset classes in the long run.
(The author is Founder and fund manager, Right Horizons)
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