It’s hard and impractical to predict the asset that gives you the highest return. Data shows that every year, the winner varies, since the market is at the confluence of multiple variables.

We know that investors should not keep all their eggs in one basket. Instead, they should ensure that the portfolio is properly diversified. The rationale behind this goes a little deeper than just keeping the eggs in different baskets. Let us scratch the surface.

We invest in various asset categories like equity, debt, gold, real estate, and commodities. The major ones, in terms of awareness and popularity, are equity and debt. The essence of diversification is that the correlation between various asset classes, be it equity, debt, gold, etc., is negative. For a given set of market conditions, different assets react differently. When the economy is buoyant, equity does better since corporate earnings are growing at a brisk pace. Bonds usually do not perform well in this phase as interest rates are moving up, and interest rates and bond prices move inversely. Gold tends to do well in periods of global uncertainty. That is when people take some money off equities and move it to the safety of the precious metal. The benefit for an investor, arising from the negative correlation of various assets, is that volatility in one market is cushioned by stability in another. This reflects well in your portfolio when assets are shifted or juggled accordingly. Note that the negative correlation mentioned above is not perfect; it is neither -1% nor -100%. But to whatever extent it is there, say -0.5% or -50%—just for the sake of a discussion, it cushions your overall portfolio volatility.

It’s hard and impractical to predict the asset that gives you the highest return. Data shows that every year, the winner varies, since the market is at the confluence of multiple variables. On one hand, the allocation in your portfolio is based on the historical performance of that asset, in terms of returns generated over the long term and volatility in the interim. On the other hand, it is dependent on the investor’s risk appetite as well— how much volatility you are able to digest and your investment horizon. As for the horizon—longer the better, since it smoothens out market fluctuations. We have data, over the long term, on the returns generated by equity, debt, gold etc. and how volatile it has been.

Strategic asset allocation is about matching the nature of the investment and your suitability. In essence, your allocation decision should not be influenced by current market levels. A bullish market leads to “recency bias” in your decisions and you tend to allocate higher. Let us assume a portfolio of 60:30:10 in equity, debt and gold, respectively, for a 40-year-old person with a horizon of 20 years. The portfolio shows a bias towards equity. Historically, equity has delivered higher than gold and debt, and has been relatively more volatile. Since the horizon is long, 20 years, this will not be an issue as long as the person is okay with interim volatility. The allocation to debt and gold will provide the countervailing force in times of equity market volatility. The basis of arriving at 60%equity and 40% non-equity countervailing force is that the investor has a moderately high preference, more than 50%, of earning relatively higher returns. However, the investor does not want to go aggressive on his bets, hence there is moderation in the portfolio at 40% allocation.

Tactical allocation is all about fine-tuning the assets in your portfolio as per the broad economic framework and market valuations. Do note that the basis for tactical allocation is not just the prevailing market level, say the Nifty/Sensex level or 10-year government security yield level. There is a difference between price (for example, the Nifty/Sensex level) and value. In terms of market valuation, such as price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, expected earnings growth, etc., the allocation in your portfolio may be tactically changed to, say, 70:20:10 between equity and debt if equity valuation looks attractive. If market valuation looks stretched, let’s say, if it is near a bubble zone, then the allocation may be tweaked to 50: 40:10.

Even within an asset class, diversification is required. There are identifiable risk-return features in asset sub-classes. In equity, the conventional approach is to go by market cap —in terms of large-cap stocks, small-cap stocks, etc. Historically, small-cap oriented mutual fund schemes have delivered higher returns than large-cap ones, but volatility has been higher as well. In debt, funds are laddered as per portfolio maturity; higher the maturity, higher is the return expectation, but volatility is higher as well. You have to opt for tactical allocation where it concerns sub-classes.

Source: https://www.livemint.com/money/personal-finance/the-importance-of-diversification-in-your-investment-portfolio-understanding-asset-allocation-and-tactical-allocation-11691514476669.html