Investing is, in essence, moving the date of consumption to the future. This means that all investing must try to beat inflation. The secondary objective is to generate a sufficient rate of return that ensures that objectives are met and the investing journey is manageable.
Asset Allocation and Asset Classes
The choice of asset classes and their respective allocations play an important role. An exceedingly conservative allocation mix may lead to unsatisfactory returns.
At the same time, an excessively aggressive allocation mix may result in short term loss of capital and high volatility during the investing journey.
Among the asset classes recommended, Indian Equities has the best return profile. Over an extended period of time, Indian Equities gave an average return of ~14%.
This performance, though, comes with volatility and a temporary period of capital loss. That being said, as investing time horizons increase, the probability of low returns diminishes.
Influence of probabilities
If we consider our first objective as avoiding a loss, we see that there is a 90% probability of not making a loss from Year 5 onwards. The probability of achieving a growth rate above 10% (this is important considering our growth assumption) is higher starting from the 6-year mark.
Over the past 24 years, Indian Equities have seen 7 instances where the portfolio value has fallen in excess of 20% from the peak. This is what we refer to as Drawdowns.
These drawdowns tend to spook investors and have been a major reason for investors cutting short the investment journey.
Adding additional asset classes (especially ones that have different risk and return profiles) leads to a smoother investing journey. This thereby leads to a higher probability of investors staying invested.
Below is a chart that compares the drawdowns of Indian Equities with a recommended asset allocation strategy.
The asset allocation strategy is designed in a manner that helps reduce the downside risk while not making a very large dilution in return characteristics. The Asset Allocation strategy used in the example above has an average 10 Year Return of 13.6% as compared to an average of 14.3% for Indian Equities (Single Asset Class).
The adherence to an asset allocation mix may lower returns marginally. However, it will control the downside materially and this, in our view, will be considerably better for an investor.