Pure Equity Vs Asset Allocation: Which is better?

Investing can be a challenging task, especially when deciding between a pure equity portfolio and a diversified portfolio. This blog will compare the performance of a pure equity portfolio against diversified portfolios with different equity-debt allocations. The goal is to understand if diversification, a strategy of spreading investments across various asset classes pays off in the long run, both in terms of returns and risk management.

The portfolios for comparison

The analysis considers four different investment strategies:

Pure Equity Portfolio: Invests solely in equities, specifically the Nifty 50 Total Returns Index (TRI)

70:30 Portfolio (Equity: Debt): Allocates 70% in equity (Nifty 50 TRI) and 30% in debt (I-Sec Sovereign Bond Index)

80:20 Portfolio (Equity: Debt): Has 80% investment in equity and 20% in debt

60:40 Portfolio (Equity: Debt): The most conservative with 60% in equity and 40% in debt.

Analysis

Each portfolio was analysed based on a theoretical monthly Systematic Investment Plan (SIP) of Rs 20,000, from April 2008 to April 2023. This 15-year period provides a comprehensive view of the portfolios' performances across various market conditions. The portfolios were rebalanced annually every April to maintain the set asset allocation ratio, an essential part of the strategy.

Comparative analysis and findings

Pure Equity vs. 70:30 Portfolio

The pure equity portfolio showed a higher final return as compared to the 70:30 portfolio.

However, the 70:30 portfolio showed superior resilience during market downturns, with smaller drops in value. This indicates better risk management and downside protection.

Pure Equity vs. 80:20 Portfolio

Similar to the 70:30 portfolio, the 80:20 portfolio yielded slightly lower total returns but provided better protection in volatile markets. This balance suggests that even a small proportion of debt can significantly impact risk mitigation.

Pure Equity vs. 60:40 Portfolio

The 60:40 portfolio being the most conservative had the lowest returns but offered the highest safety during market corrections. This portfolio is particularly suitable for investors who prioritise capital preservation over high returns.

The benefits of equity

Higher growth potential

Pure equity portfolios typically offer higher returns over the long term, capitalising on the growth potential of the stock market. Equities often outperform other asset classes like bonds or cash over extended periods, making them a powerful tool for wealth accumulation

Benefit from market uptrends

 During bull markets, there is appreciation in pure equity portfolios, offering substantial gains to investors. Investors can fully capitalise on positive market trends without the dilution effect of lower-yielding debt securities

Compounding returns

Equities offer the potential for compounding returns, where the earnings are reinvested to generate additional earnings over time. This compounding effect can increase wealth, especially for long-term investments

Diversification within equities

Pure equity portfolios can be diversified across various sectors, industries and geographies, reducing specific market risks. This diversification within equities can offer a balance between risk and returns, even with a purely equity-focused strategy

Inflation hedging

Over time, equities have shown the ability to outpace inflation, preserving the purchasing power of investments. By investing in growth-oriented equities, investors can protect their wealth from eroding due to inflation

Liquidity

Equities generally offer higher liquidity as compared to other investment types like real estate or certain fixed-income securities. This liquidity allows easier access to funds and flexibility in investment strategy.

The benefits of asset allocation

Downside protection

One of the most significant advantages of a diversified portfolio is its ability to cushion against severe market dips. This is particularly beneficial during sudden market crashes or prolonged bear markets, where pure equity portfolios might suffer substantial losses

Reduced investment anxiety

Market volatility can be a source of stress for investors. Diversified portfolios, due to their lower volatility, can help investors stay calm and committed to their long-term investment goals.

Automatic rebalancing

This strategy involves periodically adjusting the asset allocation to maintain the desired ratio. For instance, in a rising equity market, the equity portion of a portfolio can grow beyond the desired percentage. Rebalancing involves selling some equity (booking profits) and buying debt, thus maintaining the balance. Conversely, in a bear market, rebalancing would mean buying more equity at lower prices and selling some debt, effectively implementing the 'buy low, sell high' principle.

Making the right choice: Equity vs Asset Allocation

Choosing the right mix between equity and debt depends on individual circumstances:

Age

Younger investors often prefer equity due to a longer investment horizon, Higher equity allocation capitalises on their ability to withstand short-term market volatility for long-term gains.

Risk tolerance

Risk-averse investors tend to lean towards a higher debt allocation, Higher debt allocation aims to reduce portfolio volatility and protect the capital. 

Investment horizon

For short-term financial goals, a higher debt allocation is advisable for stability. For long-term goals, a portfolio dominated by equity is often chosen for its potential for higher returns over time.

The role of market timing and investment psychology

An important aspect of investing is the psychological challenge of market timing. Many investors struggle with the decision of when to enter or exit the market. Diversified portfolios with regular rebalancing automatically navigate these decisions, thereby removing emotional biases and helping maintain a disciplined investment approach.

Conclusion

While pure equity portfolios may provide higher returns in a bullish market, diversified portfolios offer a more balanced approach. They not only reduce the risk but also smooth out the investment journey, making it more bearable during market downturns. Moreover, the practice of rebalancing within these portfolios ensures that the investors can capitalise on market movements without having to make complex timing decisions.