The ongoing financial crisis and the economic slump has had the interesting affect of bringing attention back to some of the basics of investing. The media takes it as generally accepted that 'investments are down 60 per cent'. What that means is that the Sensex is down by 60 per cent (roughly) from the peak it hit. It doesn't mean, even roughly, that 'investments are down 60 per cent'. That would have been the case if people's investments were down to 40 per cent of what they had invested. This would be true only for those who have made all their investments near the peak of the stock markets, or those whose investments have mostly fallen by 80 or 90 per cent. Such cases exist, but they can hardly blame anyone else.
In my experience, most real mutual fund investors' actual losses are far less than their notional losses because they have typically invested over a longer period of time and in a wide variety of assets. This has protected them from catastrophic losses because such a pattern of investing conforms to some of the basic principles of investing.
Two of the most fundamental 'back to the basics' ideas in investing are diversification and asset allocation. Diversification simply means that an investor should spread around his investments in a mix of different types that are likely to balance out each other's bad times. Whenever one type of investment in a diversified portfolio does badly, others should do well. This ensures that the entire portfolio does not do badly simultaneously. To some extent, diversification inevitably means that the entire portfolio will not capture all available gains simultaneously but that's the price one pays for relative safety. Diversification is essentially a safety technique. What sharpens diversification in practice is asset reallocation. Conventionally, asset reallocation means making sure that a pre-determined balance between various asset types is maintained.
Diversification is practiced along many types of parameters like companies, sectors and geographical regions. However, the classic type diversification that tends to offer the greatest impact is between debt-backed investments and equities. This is what is practiced by a wide variety of mutual funds available to the Indian investor. Depending on the level of conservatism these funds offer, they could set the balance between debt and equity to anything from 10 per cent equity to 75 per cent equity with the remainder in debt.
One of the more interesting ideas in asset allocation is to change the balance according to market conditions. The concept is that over medium to long terms, equity markets inevitably move in cycles. There is a part of the cycles where equities are clearly underpriced and there are parts of the cycle when equities are clearly overpriced. In the former, one should give more weightage to equities and in the latter, less weightage. Then, as the markets go through their cycle, the investor will be best able to capture an optimum level of safety with that of returns. The idea is quite sound and has proven its worth in other markets.
Does it work in India? Unfortunately, one doesn't know. There are just a handful of asset-allocation funds in India and none of them have done particularly better or worse than other funds. Only a couple of them have been around long enough to go through a complete market cycle.
In the months and years to come, mutual funds that make protection as part of their fund design will play a far greater role than they have so far. Inevitably, the primary question that investors ask about a fund should shift from 'How well will this fund earn?' to 'How well will this fund protect earnings in bad times'.