Gaurav Sud

Mar 2016

Classical Wage Earner Dilemma

delay by 3 years

What is Asset Allocation

Asset allocation is the implementation of an investment strategy
that attempts to balance risk versus reward by adjusting the
percentage of each asset in an investment portfolio according to
the investor's risk tolerance, goals and investment time frame

Different Asset Classes

Real Estate
Debt

Equity
Gold
Commodities
Cash
Assets in other currencies

Why Is Asset Allocation Important?

Asset allocation relies on the notion that different asset classes offer returns that are not
perfectly correlated and diversifying portfolios across asset classes will help to optimize risk-

adjusted returns

In a seminal paper in 1986, Determinants of Portfolio Performance BHB study asserted that

asset allocation is the primary determinant of a portfolios return variability, with security
selection and market timing (together, active management) playing minor roles

In 1997 William Jahnke published a critique of the BHB study in which he argued: The
fundamental problem with BHBs analysis is its focus on explaining return volatility rather than

portfolio returns

In The Equal Importance of Asset Allocation and Active Management from 2010, Ibbotson
studied 10 years of returns for more than 5,000 mutual funds in order to measure the relative
importance of asset allocation policy versus active portfolio management. Their Conclusion
About three-quarters of a typical funds variation in time-series returns comes from
general market movement, with the remaining portion split roughly evenly between
the specific asset allocation and active management

SOURCE: CFA Blog Setting The Record Straight on Asset Allocation - 2012

Need to Save More

Wage Earners vs Pensioners Ratio

Assets Risk Profile

Investments that are riskier have to

appear to likely generate higher

returns, else people will not make
them

Investors carry the following

challenge

Taking higher risks for generating higher

returns and getting hit by an unforeseen

event

achieving it

Source : Howard Marks

(Oaktree Capital)

Targeting lower returns to eliminate risk and

Goal should be to look for mispriced

bets

'We have two classes of forecasters: Those who don't know and those
who don't know they don't know
John Kenneth Galbraith

Risk in Assets
Volatility (classic academic definition) vs permanent loss of
capital
Future is largely unknowable
Very difficult to quantify risk, but one can think in terms of range
of outcomes
Generally
As an asset declines in price, people view it as riskier but it actually becomes
less risky
As an asset appreciates making people think more highly of it, it becomes riskier

Higher the risk, higher the returns may not always hold true
(mispriced bets)
On the other extreme efforts to reduce the risk of loosing money
invariably increases the risk of missing out on better returns

Underestimating Risk

Never forget the 6 foot man who drowned while crossing a stream that was 5
feet deep on an average

Question?
How much of your networth is in equities?

A. Less than 10%

B. Between 10% to 30%

C. Between 30% to 50%

D. More than 50%

Something to think on
Those having less than 10% the question to be asked is
Is this a conscious decision that I have taken? Will this really move the needle?

For the golden rule of making money is, its not which stocks you
picked in the bull market but how much of your networth was
invested in stocks

Those having more than 50% the question to be asked is

Do I have the risk appetite to handle the volatility that come with the fluctuation
of the market?

A person having say 80% of his networth in the stock market may
want a much more diversified portfolio than one having 10%

What drives asset allocation decisions

Your age

(The popular 100-AGE allocation rule between equity and debt)

The quantum of savings

(High amount of savings tend too be more focused on debt or

real estate)

How you have made money in the past

(statistically cheap, MNC Stocks, IPO,

Cyclical, Sectors etc)

Your profession (Full Time investor vs Part Time)

Your temperament

(Everybody has a different risk appetite)

Your responsibilities (A person with 3 kids vs one with no kids)

Which City you are in

(Mumbai vs Chennai vs Ahmedabad)

At what moment did you start saving

have a very different view than those in 2008)

(People who started investing in 2014

So what is Ideal Asset Allocation

The decisions are based on
Your positions in life
Your risk appetite
Your temperament

Your return expectations

There is nothing that can be called ideal

A person who is full time into investing may need to be more
prudent than someone who has other significant income sources
The overall capital deployed also has a role to play (Over time
with significant capital, the idea of CAPITAL PRESERVATION
comes into play)
What is important is that you do a Asset Allocation consciously
rather than it being a unplanned default mode

Delayed Gratification A powerful concept

Delayed gratification is the ability to resist the temptation for an
immediate reward and wait for a larger reward later

LETS DO A THOUGHT EXPERIMENT

Say you want to buy a car for 3 lakhs, or a trip to Singapore costing 1 lakh
Delay by 3 years whatever are your desired big ticket spending plans

ASSUMPTIONS

Annual Income of Couple (Rs Lakhs)

10

Income Growth Rate

15%

Household Expenses (Rs Lakhs)

Expenses Growth Rate

15%

Savings after all household expenses

(Rs Lakhs)

Inflation in big ticket items

10%

Big ticket expenses (Rs Lakhs)

Investment Returns

15%

Net Savings (Rs Lakhs)

Big ticket Item as a %ge of Income

20%

Delayed Gratification
Without Delayed Gratification

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 10

Year 15

Year 20

Figures in Rs Lakh
Household Income

10.00

11.50

13.23

15.21

17.49

20.11

40.46

81.37

163.67

Household Expenses

7.00

8.08

9.32

10.76

12.41

14.33

29.32

60.00

122.80

Gross Savings

3.00

3.42

3.90

4.45

5.08

5.79

11.14

21.37

40.86

Big Ticket Purchases

2.00

2.30

2.65

3.04

3.50

4.02

8.09

16.27

32.73

Investment Pool - Opening Balance

1.00

2.27

3.87

5.86

8.32

31.29

87.77

217.40

Returns on the Pool

0.15

0.34

0.58

0.88

1.25

4.69

13.17

32.61

Savings for the year

1.00

1.12

1.26

1.41

1.58

1.76

3.04

5.09

8.13

Investment Pool - Closing Balance

1.00

2.27

3.87

5.86

8.32

11.33

39.03

106.03

258.14

With delayed Gratification

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 10

Year 15

Year 20

Figures in Rs Lakh
Household Income

10.00

11.50

13.23

15.21

17.49

20.11

40.46

81.37

163.67

Household Expenses

7.00

8.08

9.32

10.76

12.41

14.33

29.32

60.00

122.80

Gross Savings

3.00

3.42

3.90

4.45

5.08

5.79

11.14

21.37

40.86

2.40

2.76

3.17

6.38

12.84

25.83

Big Ticket Purchases

Investment Pool - Opening Balance

3.00

6.87

11.81

15.63

20.29

62.79

166.05

404.88

Returns on the Pool

0.45

1.03

1.77

2.34

3.04

9.42

24.91

60.73

Savings for the year

3.00

3.42

3.90

2.05

2.32

2.61

4.75

8.53

15.03

Investment Pool - Closing Balance

3.00

6.87

11.81

15.63

20.29

25.94

76.96

199.49

480.65

Asset Allocation My Strategy

Influenced by the work of David Svensen (CIO of Yale Endowment since

1985)

Svensen developed the Yale Model largely followed by endowments

globally (Yale Endowment has Assets of USD 25.6 Billion as on 30 Jun
2015)

In his book Unconventional Success he highlighted that

The investor should construct a portfolio with money allocated to core asset classes, diversify

among them and have a bias toward the equity sections

The investor should rebalance his portfolio on a regular basis

There is an inbuilt hedging mechanism built into the system, whose core
tenet is mean reversion

After a certain size, capital preservation is equally important as returns on

the capital

Asset Allocation My Strategy Contd

Ideal
Actual
Allocation Allocation

Asset Class

Review the asset classes you want

to have exposure to (for me its

largely equity, real estate & debt)

Equity

60%

60%

Real Estate

25%

25%

Debt

10%

10%

Cash & Other Assets ( Gold,

Silver, Art)

5%

5%

change with age and thinking

process)
Work on moving the actual

allocation to the ideal one (I did

Ideal
Actual
Allocation Allocation

Equity

60%

75%

Real Estate

25%

17%

Debt

10%

5%

Cash & Other Assets ( Gold,

Silver, Art)

5%

3%

Year 1

Think the kind of allocations one

wants (Not cast in stone and can

Year 0

Asset Class

the same within a year in 2010)

Review the allocation twice a year

(The Year 1 table will clearly

highlight the action to be taken)

In the example equity had a good

year (as in 2014)

Play on mean reversion

Valuations My Strategy
SENSEX VALUATIONS
(HISTORICAL)

MAXIMUM
MINIMUM

SENSEX SENSEX
PE
PB

57.42

10.25

SENSEX
DIV
YIELD %

Track the overall levels of the market

Broad Strategy is to

0.46

9.83

1.67

4.40

MEAN (AVERAGE)

20.94

3.72

1.42

MEDIAN

19.15

3.54

1.34

100% invested at (Mean 1 Sigma)

90% at Mean

75% at (Mean + 1 Sigma)

<50% at (Mean + 2 Sigma)

As I move to cash I have the ability to

deploy Risk Arb situations

Look for GARP (Growth at Reasonable

Price) stories
STANDARD DEVIATION

8.19

1.24

0.45

MEAN + 1 SIGMA

27.28

4.97

0.98

MEAN + 2 SIGMA

47.26

6.66

0.64

CURRENT VALUATION
(11 MAR 2016)

18.50

2.69

1.45

COUNT

5,124

5,124

5,124

Do not chase quality at any price

(valuation has to be right)

I do run the risk of being too risk

averse and missing out on some great

opportunities and so lowering my

overall returns

Investing Checkpoints
In Investing one needs to be an optimist. You are making a
hypothesis about a industry, business or management and hoping
that that it play out
So be an optimistic investor but do your asset allocation in a way
that you can financially handle the potential wealth destroying fat
tails
Do not use leverage for the negative results of the same can be
catastrophic
Having very high return expectations can make you do foolish
things
Focus on having assets that allow to maintain your living standard
no matter what

Conclusion
Dont put the money YOU HAVE and YOU NEED at
RISK to earn money THAT YOU DONT HAVE AND

DONT NEED

Only RISK the money that YOU HAVE and

DONT NEED

DISCLAIMER
I am not an Investment Advisor. Any stocks discussed are for
educational and discussion purposes only and are not
recommendations to buy or sell stocks.
I may or may not have a position in the stocks discussed. For
any investment decision, please contact a certified investment
advisor

Gaurav Sud
gaurav@kanavcapital.com