A regular and fixed monthly investment over the period January 2008 - December 2012 in a well-known debt fund would have given a CAGR (compounded annual growth rate) of 8.43%. If the same amount was split between the debt fund and the NIFTY index through an ETF in a 50:50 split, the CAGR would increase to 9.05%. But if certain adjustments are made in the proportion depending upon the market conditions, the CAGR can be enhanced to 9.55%. For example, when market valuation is comparatively lower then more than 50% investment is made in NIFTY and when market valuation is comparatively higher then less than 50% investment is made in NIFTY. Now, if 20% of the overall allocation is made in Gold then the CAGR goes up to 11.92%. The table below summarizes the different scenarios.

As can be seen, proper asset allocation provides return enhancement and risk management. Dynamic asset allocation strategy changes the allocation to a particular asset class depending upon its valuation. If executed in a timely manner, a dynamic asset allocation strategy can book profits and deliver higher returns.

Every asset class has a particular return-risk characteristic that one needs to be aware of when creating investment portfolios. Following are some of the important points to keep in mind:

1. One of the criteria to add an asset class is the diversification and different return-risk characteristics it provides. For example, an investment in NIFTY index may be similar to investing in a basket of Large Cap Stocks. So it may not be a good strategy to have two separate asset classes - one for NIFTY index and second for Large Cap Stocks.
2. Do not expect all asset classes to behave the same. Like hammer and wrench have different functions, the various asset classes also have different roles to play. For example, when the stock market is in decline, large-cap mutual funds may show lesser reduction in value as compared to the mid-cap mutual funds. Similarly, even when the Sensex has touched 20000 recently, some of the sectors like infrastructure, capital goods and mid-cap stocks have not really performed. It is normal for up and down movements of asset classes (a.k.a. volatility) to be quite different when market moves up and down.
3. Asset classes can be mixed in various proportions to create client investment portfolios as per the desired risk profile. It is important to adhere to this principle strictly to ensure that the investment portfolio volatility is acceptable to the client.
4. Risk should be managed by keeping maximum limits on individual investments
5. Finally, investors do show lesser appetite for risk when markets are down as compared to when markets are up. It is important to make the clients aware about the market cycles and the worst-case scenarios.

Some of the asset classes, their characteristics and the role that they play in asset allocation are captured in the table below. The list is not exhaustive and shown for illustrative purpose only.

Clients need to be well aware of the characteristics of an asset class, typical holding period and expected CAGR before determining its allocation in their portfolio. Returns should always be looked from overall asset class and portfolio point of view rather than individual investments. In cases where the fundamentals of an investment may have changed, immediate action should be taken even if it means booking a loss.

In summary, clients should adhere to the Seven Steps in the Process of Investments (Read earlier article on this topic https://medium.com/mithoughts/seven-steps-in-the-process-of-investments-f68266860c56

The writer is the Managing Director of Mitraz Financial Services Pvt. Ltd and can be contacted at anup.bansal@mitrazonline.com