Making of Glide Portfolios – Part 2- Asset classes
In our previous blog, we learnt about the need to create wealth in order to beat inflation and maintain a high quality of life while being able to meet increased healthcare and other lifestyle expenses. Let us talk about the various asset classes available for investment that will aid you in your journey towards wealth creation.
INVESTING IN ASSETS:
Without going into any specific accounting or general definitions, assets at their simplest are instruments or resources of value that appreciate its value over time as well as generate income. So land or property providing rental income is an asset. Similarly, fixed income securities like bonds or fixed deposits that provide interest can also be called an asset.
Conversely, liabilities are those that do not appreciate in value or generate income but instead require additional capital for their maintenance and upkeep. Hence a car or a mobile phone may be an asset from an accounting point of view but as an investor, they are nothing but liabilities.
Types of Assets
Wealth creation is a function of investments into various asset classes which can be broadly categorized into five broad categories as below:
Equity as an asset class consists of shares of companies listed on the stock exchange. A share is a document signifying ownership rights of a company and investing in equities involves the acquisition of shares of various companies thus effectively making you a part-owner alongside other shareholders in the company. As an asset class, equities are the only ones to consistently beat inflation, having beaten inflation 100% of the time when held for 15 years or more. The downside to equities is their volatile nature and high returns often come at the cost of high risks. There is a very real possibility of losing money in equity markets and thus an element of diversification is required to mitigate the risks which are where other assets come into the picture.
FIXED INCOME SECURITIES
Fixed income assets, as their name suggests involves investing in assets that promise and generate a fixed rate of return. In general, they tend to be low risk, secure instruments which provide you with a guaranteed, albeit low return.
Various forms of fixed income instruments exist from recurring and fixed deposits in banks to post office savings schemes to bonds and debentures issued by government and corporates. Fixed income instruments add an element of stability since their promised rate of return is generally fixed and well known thus leading to relatively lower volatility in their prices compared to equities. As per the RBI website, the 10-year Treasury bond of the Indian government yields a return of 6.2% as of September 10, 2021, i.e. an investor investing in that bond will earn 6.2% of their investment as interest.
Gold has been a coveted asset since ancient times. Its attractiveness which originally stemmed from its yellow sheen has translated into universal acceptance as an alternative to currency. It is also negatively correlated to equities, especially during the crisis which simply put means that it tends to move in a somewhat opposite direction to equities. Hence during a market crisis, while equities are losing value, gold tends to increase in value as investors choose to move their money into a hard yet liquid asset like gold. This flight from safety to gold has also given it a moniker of a safe haven asset and as such its inclusion serves to diversify the portfolio and protects it during adverse market events.
Real Estate i.e. land and property has been a preferred choice of an asset for generations. Originally a source of power (feudalism and the ‘zamindari’ system), real estate has evolved to become an investment and a source of income. It is to be noted that acquiring a home where you live cannot be considered an investment in real estate. Real estate in investment terms refers to commercial and residential rental properties that can generate rental income.
Commercial properties were historically beyond the reach of a common investor requiring deep pockets and extensive influence to be able to access them. It was, however, democratized by the invention of Real Estate Investment Trusts (REITs). REITs pool money from investors like a mutual fund and invest in commercial properties. Rental income is distributed to those investors via dividends. Today one can acquire real estate in the same way they can acquire shares and bonds, via a Demat account. REITs allow one to invest in real estate with small amounts and add a flavour of diversification combined with the possibility of capital appreciation in the portfolio.
Cash on its own in a physical form will not generate any income unless it is kept in a bank or other liquid sources. However, what makes cash an asset to hold is its direct and easy convertibility into any other asset form.
It is always recommended to have an emergency fund containing at least a year’s worth of expenses in liquid form i.e. in readily cashable securities. A small portion of cash in the portfolio also allows for allocation to various assets during a market dip as well as serve as a cushion in adverse effects. Thus cash is an essential part of an investment portfolio but should be limited to a small portion and under emergency fund only.
Now that we know about various assets, let us look at the role asset allocation plays in our investment decision.
Why is Asset allocation?
There is a famous universally recognized idiom that circulates around investments and life decisions – “Do not put all your eggs in one basket”. The same is applicable while making asset class selections for your investments.
The above image proves the truth of the idiom in a clear and lucid manner. Each column contains the annual returns of that asset class in that year with colour coding representative of the overall asset class. It can be clearly seen that no single asset class has delivered consistent performance year on year. Some years equities have delivered the best (2017) whereas in some years they have delivered the worst (2018).
This makes investing all your money in one single asset class really difficult both intuitively and emotionally. Even for the bravest amongst us willing to invest all their wealth into a single asset class, a drop of 20 odd % will shake our belief in that investment making us take decisions that will hamper our wealth creation journey. Asset allocation plays an important role in mitigating this volatility of returns.
If we were to ask you to choose from the following options, the factors that would impact your investment returns, what would your answer be?
- Security Selection
- Market Timing
- Asset allocation
- Other factors
As per a study, “Determinants of Portfolio Performance”, conducted by Brinson, Hood et al, Asset allocation contributed about 91.5% to your investment performance results.
To demonstrate the actual effect observed in the study, a sample portfolio constructed with equal weightage to four asset classes, Equity, Debt, Gold and Liquid Fund (Cash) was constructed.
This portfolio delivered a CAGR of 11.1% over the last 14 years with only one year of negative returns of -1.3% during the year 2008 when the world was in a midst of the Great Financial Crisis.
Why asset allocation is a must?
The reason asset allocation works when done properly is due to the property of correlation. Correlation in investment terms refers to the relationship between two asset classes in their performance (magnitude and direction). The same shall be clear with the following graphs.
Graph 1 - Source: MOAMC, Calendar Year Returns of Equities
Graph 1 has plotted the calendar year returns of different equity indices over the last 15 years. Equities as a whole are one asset class. Therefore all the various indices be it large-cap, mid-cap or small cap are all highly correlated with each other which can be seen as all of them rise and fall at once. The direction remains the same, magnitude differs. Thus investment in only equity will be subject to immense volatility making it difficult to stay invested over the long term.
Graph 2 - Source: MOAMC, Calendar Year Returns of various asset classes
Graph 2 shows calendar year returns but this time of different asset classes. One can see that there is a vast difference in both magnitude and direction of different asset classes with some asset classes even moving opposite to each other as in 2013 when S&P 500 index has moved up while gold and Nifty 500 have moved down. A portfolio comprised of these asset classes will tend to be smoother and stable while generating competitive returns ensuring that an investor can stay invested for the full term required for wealth creation.
It is with this principle in mind that we at Glide chose asset allocation as the base for constructing a goal-based portfolio. However it is not simply enough to have an asset allocation, that allocation must be tailored to each individual’s risk and investment horizon and at the same time be efficient. In the final part of our blog series, we will run you through efficient portfolios and how the Glide portfolios were brought to life.