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Equity allocation in your investment portfolio - Views on News from Equitymaster
 
 
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  • Dec 27, 2005

    Equity allocation in your investment portfolio

    We had recently conducted a poll asking investors about their preference towards different asset classes as investment avenues. The choice had to be made between equities, fixed income securities and gold. More than 50% of the respondents preferred to invest into equities, whereas more than 35% preferred gold. At the current juncture, when the indices are scaling new heights, economy is in pink of the health, higher amount of global money is allocated to India and there is an increasing optimism towards equity markets with each passing day, we were not really surprised by the overwhelming response towards equities. Similarly, the preference towards gold appears to be the result of the recent run up in the gold prices. However, a prudent investment decision should not be based on the past performances but on the expected future trends.

    In this article we shall highlight some of the key fundamental aspects that should be kept in mind before deciding on one's equity allocation.

    How much to invest in equities? This is one of the key fundamental questions that an investor needs to ponder upon. While the final decision on the structure of investment portfolio depends on a number of factors, the decision should be based on the long-term requirements. For instance, five years down the line, you may need to buy a house or there may be a marriage in the family and so on. Similarly, the decision should also be based on the ability to bear the risk associated with an investment class. Given the improving infrastructure, sectoral reforms and productivity improvements, the economy appears to be in good shape and hence the performance of corporate sector. Hence, we feel that equities will continue to give relatively higher returns. However, in case of downturn, equities, as a class of assets, are the biggest losers. This factor assumes importance when one looks at the historical performance of the Indian economy, which has been volatile. When the next round of subdued performance will kick in is anybody's guess.

    When to invest? This is another fundamental question that has an important bearing on the performance, especially the equity portion of the portfolio of an investor. While we are not saying that one should try to time the market, what we indicating is that there is always an opportune period of investing, especially from a long-term perspective. The trick lies in identifying the same. For instance, in a capital-intensive industry like automobiles, the opportune time to invest is when the company has commenced its capex cycle. Incidentally, many of the 'experts', give a cautious view during such times, as the profitability is likely to be depressed due to higher depreciation and interest charges.

    Where to invest? For a long-term investor, this is another key to the investment decision in the equities. Ideally, from a long-term perspective, the investment should be in those sectors or stocks where there is visibility of growth. Similarly, one should also consider the degree of immunity that the investment provides against the cyclical risks associated with the performance of the economy. For instance, in the telecom sector, there exists a certain amount of visibility in terms of the increase in the subscriber base in next five to eight years. If one peeps into the past, the visibility was much stronger than it is today (at that time the call charges were significantly high and there were expectations of decline in the same). While we are not suggesting lapping up the telecom stocks, what we are trying to point is that, over a longer horizon, a prudent foresight should yield results.

    Valuation: As far as equities are concerned, valuations are the culmination of the entire investment process. An investment decision should be driven by the prudence, which is determined by the valuation that the stock is currently enjoying. To correlate our previous argument on the visibility aspect, today most of the telecom stocks are enjoying rich valuations (around 35 times their trailing 12 months earnings), when compared to broader indices. This requires caution, as one needs to decide whether the company has the capability to grow atleast at this pace going forward.

    To conclude, the asset allocation in an investment portfolio should be in line with the long-term objectives and the risk profile of an investor. For investing in equities, one should stick to the companies that have a good management at the helm of affairs, a relatively diversified and sound business model and a fair amount of visibility. Happy investing!

     

     

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