It's time to raise your equity allocation

Asset allocation plays an important role in balancing reward and risk in the investment portfolio, and till date it is the most superior determinant of investors' success in the long term.

Equity and debt being the two main financial asset class, the right mix between the two is crucial for an average investor to achieve his financial objectives.

There is no set formula to define the right asset allocation for an individual, however, there are three important factors which help one derive the most suited allocation – investment horizon, liquidity requirement and risk appetite.

Over the last 18 months, the Reserve Bank of India has reduced interest rates 1.50%, with last of the announcement made in April 2016. In this scenario of falling interest rates, it becomes increasingly easier for corporate/individuals to borrow money which helps finance their expansion/aspirations at a reduced interest costs.

Besides helping business investments, lower interest rates also positively affect consumer psychology and help increase consumption. While the positive effects are numerous, it is important to understand that there is generally a 12-18 month lag for the impact of interest rates changes to be felt in the economy, meaning that it will take at least 12 months for the effects of any decrease in interest rates to span out properly.

Last two-three months have witnessed a positive trend in the economic activity on few critical parameters:

(1) The data on projects getting cleared and awarding of orders has gone up in recent times.

(2) Industrial activity has picked up with output of core infrastructure industries expanded by 8.4% year-on-year (yoy) in April 2016 (versus 6.4% yoy in March 2016), at a four-year high, albeit partially on account of favourable base effect.

(3) Recovery in rural demand given government's focus on rural spending and projected normal monsoon – revival of the rural economy would also have a multiplier effect on sectors that are driven by consumption – these sectors include consumer goods, FMCG, autos (two-wheelers in particular), etc. This revival in demand and consumption would eventually translate to increase in private capital expenditure turning the whole economic circle positively.

The pick-up in activity is not only restricted to macro variables alone but is also visible in the last quarter corporate earnings as well. For CNX 500 firms, excluding energy and BFSI, net sales growth and profit growth for the March quarter was the best on record since the June 2014 quarter. This means, in last quarter, we have seen an increase in corporate earnings growth after a long lean phase (six consecutive quarters of declining earnings growth), although this is partially driven by low base effect in the same quarter of previous year.

This clearly suggests that the lag impact of interest rates and key government reforms have started to impact and greenshoots in the economy are now visible. It could be just a matter of time that earnings growth comes back in a more meaningful way.

In this phase of the economy, higher allocation in equities is desired for the long-term investment portfolio. Given that the street estimates corporate earnings to grow at 15%+, the consequent increase in share prices can beat the underlying inflation (currently at approximate 5%) by a very wide margin. However, investors must have a horizon of 3-5 years to expect meaningful returns from equities.

One must consider his own investment horizon, liquidity requirements and risk appetite before increasing his allocation towards equity markets and invest in a staggered manner. For retail and first-time investors, SIP is the best route to take exposure to equity markets.

The writer is senior group president retail and business banking, YES Bank