Any investor who has spent reasonable time in the stock market would know that no one asset class will generate the best returns at all times. There are times when investing in the equity market may mean better returns than investing in the debt market, or vice versa. Having invested in the right asset class or the right balance of the two could have a huge bearing on whether or not an investor is able to create wealth for the long term. This is where an asset allocation based approach trumps a piecemeal approach. A piecemeal approach means picking and choosing schemes without a clear objective in mind, which is how a lot of mutual fund investments occur.
The asset allocation approach
One must ensure that investments reflect the right balance at all times. Hence, if there is a sharp price rise in an asset class which alters its share in your portfolio, you may need to take measures to restore the balance.
Assume that you are a moderate risk-taker and prefer a 50-50 equity-debt mix in your portfolio worth Rs 1 lakh. Say, the stock market rises by 50 per cent. So, Rs 50,000 worth of equity may now be worth Rs 75,000 and your entire portfolio will be worth Rs 1.25 lakh. However, your asset mix is now skewed towards equity, which means you are carrying more risk. So, to restore it to your comfort level of 50-50, you need to reduce your equity holding to Rs 62,500, which means selling equity units worth Rs 12,500 and increasing your debt allocation by the same amount.
Investing in debt markets
Investors have historically looked at MFs from an equity perspective without appropriately understanding fixed income funds. Though some investors have started to look at debt MFs as serious investment options, many still carry apprehensions and continue to ignore them. But it is also important to understand that debt MFs add stability to an investor’s portfolio and, hence, are an important element of any portfolio. They not only serve as a good option to diversify investment risks, but also help a retail investor generate tax efficient income streams.