Risk-averse investors often reject the idea of investing in equity, associating it with higher risk, while viewing debt as the more stable investment option. But the assumption that equity is inherently risky and debt is inherently stable is a complete myth.
A recent study by WhiteOak Capital Mutual Fund found quite the opposite. After looking at several combinations of equity, debt and gold, the study found that over the long term, adding a small allocation to equity could actually reduce the historical volatility of a pure debt portfolio, and at the same time, improve the returns significantly.
Titled Chemistry of Investing, the study analysed average one-year rolling returns and volatility using daily data going back to September 2001. Here's a look at what it found:
The study challenges the popular concept that adding equity to a portfolio means taking on more risk.
It shows, a portfolio that invested entirely in debt delivered an average annual return of 6.77%, with volatility of 6.37%. But shifting just 10% of the portfolio to equity improved the average return to 7.97% while reducing volatility to 5.76%.
The pattern, however, does not continue as equity exposure increases. A portfolio with 80% debt and 20% equity generated a higher average return of 9.17%, but volatility rose to 6.39%—almost the same as the 100% debt portfolio, while the average return was higher at 9.17%. Beyond a 20% equity allocation, volatility increased progressively as equity exposure increased.
So, it can be said that more equity did not mean more volatility at every stage. There is, however, a point beyond which the trade-off becomes much clearer.
With a 60% debt and 40% equity allocation, average returns increased to 11.56%, but volatility climbed to 10.05%. A 50:50 portfolio delivered 12.76% with volatility of 12.40%. At 100% equity, average returns were 18.74%, but volatility rose sharply to 25.35%.
Source: WhiteOak Capital Mutual Fund, Chemistry of Investing study.
The addition of gold further helps the diversification process. The study shows that investors could raise returns without taking on a proportionate increase in volatility.
A portfolio split across 70% debt, 10% equity and 20% gold delivered an average annual return of 9.80%, while volatility stood at just 5.51%. That was lower than the 6.37% volatility recorded by the portfolio invested entirely in debt.
A portfolio with 55% debt, 25% equity and 20% gold generated an average return of 11.59%, while volatility was 6.83%—only marginally above the pure debt portfolio.
The reason lies in correlation. Equity, debt and gold do not necessarily move in the same direction or by the same magnitude at the same time. Gold, for instance, has provided downside protection during several periods when domestic equities delivered negative returns, the study notes
The numbers do not mean that a particular equity-debt-gold combination will produce the same results in the future. They are based on historical rolling returns, and the appropriate allocation will depend on an investor's risk appetite and time horizon.
But the study highlights one key principle: diversification matters. A well-diversified portfolio combining different asset classes can potentially deliver better risk-adjusted returns than relying entirely on either debt or equity.
