Let’s today understand what we mean by a balanced portfolio and why we need to have balance in a portfolio in the first place.
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Just like a balanced diet consists of adequate proportions of all nutrients like proteins, carbohydrates, fats, minerals, vitamins, fibre, etc., a balanced portfolio is an investment strategy that diversifies assets across various categories to achieve an optimal mix of risk and return. It typically includes a blend of:
- Equity: Provides growth potential but comes with higher volatility.
- Fixed Instruments: Offer more stability and income through interest payments but with lower growth potential.
- Cash & Liquid Assets: Ensure liquidity and safety, though they generally provide very low returns.
- Real Estate: Provides an inflationary hedge to the portfolio in the long run.
- Gold: Adds stability as it usually grows with inflation.
- Commodities: A distinct asset class with returns largely independent of stock and bond returns.
- Alternative Assets: Act as distinct diversification tools with the potential to perform better than other asset classes over certain periods.
The aim of a balanced portfolio is to reduce risk by diversifying investments so that the negative performance of some investments is offset by the positive performance of others. For example, during situations like war or global uncertainties such as a recession, while equity markets may correct, the prices of gold might increase, thereby creating a balance in the portfolio.
Why Do We Need Balance in a Portfolio?
Risk Mitigation: Diversification reduces the impact of any single asset’s poor performance on the overall portfolio. By spreading investments across various asset classes, the risk is spread out, making the portfolio less susceptible to market volatility.
Steady Returns: A balanced portfolio aims to provide more consistent returns over time. While high-risk investments can offer high returns, they are also more volatile. Including more stable assets like bonds helps smooth out the overall return.
Capital Preservation: Especially important for investors nearing retirement or with lower risk tolerance, a balanced portfolio helps in preserving capital by including safer investments that are less likely to experience significant declines.
Inflation Protection: By including growth assets like equity and real estate, a balanced portfolio can help protect against inflation. These assets typically have the potential to appreciate over time, keeping pace with or exceeding inflation rates.
Peace of Mind: Diversification can reduce anxiety about market fluctuations. Knowing that your portfolio is not overly dependent on the performance of a single asset class can provide emotional and psychological comfort.
Financial Goals Alignment: A balanced portfolio can be tailored to meet an investor’s specific financial goals, time horizon, and risk tolerance. This alignment ensures that the investment strategy supports the investor’s long-term objectives.
Key Behavioral Traits of Investors That Affect Portfolio Balance
Emotional Decision Making: Emotional reactions to market fluctuations can lead investors to make impulsive decisions, such as selling shares during a market downturn or chasing hot stocks during a bull market. This can disrupt the balance of the portfolio as investors may abandon their long-term strategy in favor of short-term gains or losses.
Lack of Discipline: Some investors lack the discipline to stick to their investment plan, which may include maintaining a balance between physical assets such as real estate or gold and equity. They may become complacent during bull markets or panic during bear markets, deviating from their original strategy.
Overconfidence: Overconfidence can lead investors to believe that they can outperform the market by concentrating their investments in a few assets or asset classes. However, this approach increases the portfolio’s exposure to specific risks and reduces diversification, potentially leading to higher volatility and losses. For example, places like NCR in the early 2000s saw people investing in real estate with confidence that prices would soar higher across the board.
Herding Behavior: Investors may follow the crowd and invest in popular assets or asset classes without considering their own risk tolerance or investment objectives. This can result in overallocation to certain assets and neglect of others, leading to an imbalanced portfolio. For example, during 2019-20, investors invested in cryptocurrency seeing their friends and peers invest in the same without considering its risk and reward or their financial plan.
Neglecting Rebalancing: Investors may neglect to rebalance their portfolios regularly, allowing the asset allocation to drift away from the desired balance. This can occur due to procrastination, lack of awareness, or simply forgetting to review and adjust the portfolio over time.
Chasing Performance: Investors may chase past performance by allocating more capital to assets or asset classes that have recently performed well, while neglecting underperforming assets. However, this approach often leads to buying high and selling low, as asset performance tends to revert to the mean over time.
Lack of Knowledge or Understanding: Some investors may not fully understand the principles of portfolio diversification and asset allocation, leading them to concentrate their investments in a single asset class or asset category. This lack of knowledge can result in an unbalanced portfolio that is vulnerable to market risks.
In conclusion, striking the right equilibrium for a balanced portfolio involves a detailed and methodical approach to ensure the portfolio is well-balanced, aligns with your financial goals, matches your risk tolerance, and takes into account your investment horizon. Above all, it differs from person to person as no two individuals and their life situations are the same. Hence, it has to be customized for the individual, keeping in mind a lot of qualitative aspects of that person.
