Blasé Capital  SHINES AND SIGHS

As most investors, especially the smart and savvy ones, know from experience, making profits depends on the chemistry of investments. This is exactly what a recent study, ‘Chemistry of Investing,’ tries to examine. It looks at how the various permutations and combinations of debt, equity, and bullion influence portfolio-related risks, and returns. Do not take it as a search for an ideal portfolio. Instead, consider it to be an exercise that sheds light on the “structural aspects” on how to design a portfolio that suits the risk-and-return appetite of an investor. It is more about what can offer ‘You’ the best outcome.

In search of the best design, the study calculates returns from a risk-free portfolio to the riskiest one. Obviously, the former includes one where 100 per cent of the money is locked up in bonds, which are generally considered the safest bet. Between September 2001 and January 2026, such a portfolio generated a decent annual return of nearly seven per cent, with a volatility of 6.4 per cent. The earnings are closer to what fixed deposits offer, with the large state-owned banks being ‘too big to fail,’ and volatility seems to be under control.

However, as the study shows, adding 10 per cent equity to the portfolio, and reducing the bond component by the same, hikes the returns to just over eight per cent, or addition of more than a percentage point. Surprisingly, and shockingly to some, the 90:10 portfolio reduces the volatility to less than six per cent. Bizarre as it may sound, adding risky instruments in the form of stocks, reduces the risks. Even if the ratio changes to 80:20, or 20 per cent equities, the annual earnings shoot up further to more than nine per cent, even as volatility remains below 6.4 per cent for the so-called safer all-debt portfolio.

It is only when the equity portion rises to 25 per cent, and higher, the returns improve considerably, and the risks skyrocket. In a reverse portfolio, where 100 per cent is held in equities, the annual returns are an unbelievable more than 19 per cent, but the annual volatility is more than 25 per cent. So, while returns are 2.7x higher, volatility is up by almost four times. A similar trend is visible in a 10:90 portfolio, with 90 per cent of the money locked up in stocks. The annual return is nearly 18 per cent, with a yearly volatility of just under 23 per cent.

According to the study, “Introducing a modest allocation to equity altered the risk-return profile relative to this baseline (100 per cent debt) …. It is also notable that an 80 per cent bond and 20 per cent equity combination represents almost similar volatility as a 100 per cent bond portfolio on average…. Which means the asset allocation portfolio has delivered a better risk-adjusted return than a 100 per cent bond portfolio.” Of course, there is a caveat that most experts warn about. “Past performance may or may not be sustained in the future, and is not a guarantee of any future returns,” states the study in its fine print.

To stretch the study to commodities, it adds the bullion sheen. If 20 per cent of the portfolio is allocated to gold, with 80 per cent debt, the annual return is nearly 8.5 per cent, or higher than under seven per cent for 100 per cent debt one, and volatility is lower at just over six per cent. Gold reduces the risks, and hikes the earnings. But if the gold component remains the same, and the debt part is incrementally replaced by equities, the returns zoom, and so does volatility. The debt-equity-gold mix behaves essentially the same as debt-equity mix.

In a portfolio with 20 per cent gold, and 80 per cent equity, the annual returns are higher than 18 per cent, and volatility is more than 20 per cent. In a 10:70:20 scenario, with 10 per cent allocation to debt, and 70 per cent to stocks, the returns are just over 17 per cent, with 17.4 per cent volatility. Of course, the addition of gold reduces the returns compared to one where only equities and debt are considered. This is reasonable as stocks are riskier compared to gold.

“Gold has provided some downside protection in many of the years when domestic equity has delivered negative returns, and vice versa. Various asset classes have varied degrees of correlation with each other. Economic cycles and markets across the globe are very dynamic, and it is not possible to consistently time the winning asset class, but a right mix of these asset classes may help investors achieve optimum level of risk-adjusted return to attain their long-term financial goals,” concludes the study. In effect, while once cannot buy lowest, and sell highest in each class, one can make reasonable profits through a mix.

However, we need to add a couple of warnings. In the past few years, especially after the pandemic, the rise in gold prices was phenomenal. It is obvious that this has skewed the returns in gold’s favour. Similarly, the Indian stock indices zoomed thousands of times since September 2001. The Sensex rocketed by more than 27 times, or just under 80,000 points. In the autumn of 2001, it was just over 3,000 points.