Understand Asset class behavior before investing
Sanjay (29) has been investing in the form of sips in diversified equity funds for the last 3 years as advised by his financial planner for his son’s post graduation funding which is nearly 15 years away. Of late his patience seems to have run out after seeing his equity funds portfolio in the red for quite some time now. He is thinking of stopping his sips as he now believes that the equity markets will fall more in the coming days which will further reduce his portfolio value. Mr. Rao (45) had invested a lumpsum amount in a gold savings plan a few months ago and is now ruing his decision as that fund has fallen by nearly 10% reflecting the correction in gold prices.
Many investors like Sanjay invest in equity without understanding the behavior of that asset. The very fact that unlike fixed deposits and postal savings, the returns on equity, gold or real estate are not assured which makes it vulnerable to price volatility in the short term. Each asset class is different and so is its behavior during different situations.
An understanding of the past performance of equity markets or equity diversified funds can give an indication of the volatility that’s associated with equity. Warren Buffet has famously said that “Only buy something that you'd be perfectly happy to hold if the market shut down for ten years”. This gives an indication of the long periods of uncertainty that can affect equity markets but only those who stay put with their investments are suitable rewarded. So if you do not have the risk appetite nor want to see any risk associated with your investments, then equity investments are not for you. Secondly invest in equity only if your goals are of fairly long term after having understood that you may see long periods of negative return especially in times such as the one that we are currently going through.
We have seen real estate prices going through the roof in the last 10 years. Many have forgotten the decade before 2003, when the real estate asset prices had collapsed and many investors who had invested at the peak in the 1990’s lost out big time when they sold out at a discount. Real estate as an asset class is good but again if the investment is done as a long term asset associated with your goal.
Gold has had a dream run for several years now. Many investors who invested in gold as an asset class a few years back have gained handsomely but at present gold prices have been correcting for the last few months. Therefore one need to understand that even gold prices are volatile and therefore investing in a staggered manner can be beneficial if gold has been suggested as a part of your portfolio.
This category offers a huge variety of funds to choose from depending on the time horizon. While one is at least aware that equity funds can give negative returns during certain periods, not many know that there are certain debt funds which display a cyclical pattern in terms of returns and are very sensitive to interest rate changes. Most Gilt funds and some income funds typically invest predominantly in government bonds which are vulnerable to interest rate changes. At the moment the interest rate is showing a declining trend going ahead which bodes well for gilt funds as the government bond prices increase resulting in higher nav for the funds which in turn results in higher returns. A reverse situation can pan out during the interest rate cycle going up, which can result in lower or negative returns in gilt funds.
The intention of a well diversified portfolio is to reduce risk and allocate assets as per your goals and time horizon. Secondly diversified portfolio is relevant because during different time periods, there could be one asset class which will perform better than the other. Therefore understanding each asset class before making it part of your portfolio is important in order to avoid any knee jerk reactions at extreme situations which might nullify the entire objective of building the diversified portfolio.