You are on page 1of 11

ASSET ALLOCATION

INTRODUCTION
Asset allocation is an investment portfolio technique that aims to balance
risk and create diversification by dividing assets among major categories
such as cash, bonds, stocks, real estate and derivatives.
There are several types of asset allocation strategies based on investment
goals, risk tolerance, time frames and diversification. The most
common forms of asset allocation are: strategic, dynamic, tactical, and
core-satellite.
Asset allocation is defined as:
The process of dividing investments among different kinds of assets, such
as stocks, bonds, real estate, and cash, to optimize the risk/reward
tradeoff based on an individuals or institutions specific situation and
goals. (www.investor-words.com) The process of determining which mix of
assets to hold in your portfolio is a very personal one. The asset allocation
that works best for you at any given point in your life will depend largely
on your time horizon and your ability to tolerate risk.
BREAKING DOWN 'Asset Allocation'
There is no simple formula that can find the right asset allocation for
every individual. However, the consensus among most financial
professionals is that asset allocation is one of the most important
decisions that investors make. In other words, the selection of individual
securities is secondary to the way that assets are allocated in stocks,
bonds, and cash and equivalents, which will be the principal determinants
of your investment results.
Investors may use different asset allocations for different objectives.
Someone who is saving for a new car in the next year, for example, might
invest her car savings fund in a very conservative mix of cash, certificates
of deposit (CDs) and short-term bonds. Another individual saving for
retirement that may be decades away typically invests the majority of his
individual retirement account (IRA) in stocks, since he has a lot of time to
ride out the market's short-term fluctuations. Risk tolerance plays a key
factor as well. Someone not comfortable investing in stocks may put their
money in a more conservative allocation despite a long time horizon.
Age-based Asset Allocation
In general, stocks are recommended for holding periods of five years or
longer. Cash and money market accounts are appropriate for objectives
less than a year away. Bonds fall somewhere in between. In the past,
financial advisors have recommended subtracting an investor's age from

1
100 to determine how much should be invested in stocks. For example, a
40-year old would be 60% invested in stocks. Variations of the rule
recommend subtracting age from 110 or 120 given that the average life
expectancy continues to grow. As individuals approach retirement age,
portfolios should generally move to a more conservative asset allocation
so as to help protect assets that have already been accumulated.
Achieving Asset Allocation Through Life-cycle Funds
Asset-allocation mutual funds, also known as life-cycle, or target-date,
funds, are an attempt to provide investors with portfolio structures that
address an investor's age, risk appetite and investment objectives with an
appropriate apportionment of asset classes. However, critics of this
approach point out that arriving at a standardized solution for allocating
portfolio assets is problematic because individual investors require
individual solutions.

ASSET CLASSES
The main asset classes are:
Shares (also known as equities). Shares are bought through a
stockbroker.The cheapest and fastest way to buy and sell shares is
through an online, execution-only broker. Execution-only means the
broker will take your order and implement it without giving you any
advice.
Bonds (also known as fixed-interest stocks). These are a form of
IOU issued by governments and companies when they want to
borrow money from investors. They pay a fixed level of interest, with
higher-risk borrowers paying more in interest than lower-risk
borrowers.
Property. Whether residential or commercial, property has a good
record in providing a financial return that beats inflation. Funds can
either buy into physical bricks and mortar or buy shares in property
development or real estate investment companies. Funds generally
focus on commercial property, but some buy into residential
property as well.

Commodities. There is a huge variety of commodities traded on


global markets. The range includes oil and gas; precious metals
such as gold and silver; industrial metals such as copper and iron;
and soft agricultural commodities such as wheat, rice and soya.
Just like shares and bonds, commodity prices rise and fall in
response to supply and demand, and funds can take advantage of
this.

2
Cash. It is a bit odd that cash is considered to be an asset class as
the whole reason for investing in the first place is to grow your
money faster than if it was left in the bank or building society.
However, cash provides a useful benchmark for all investment.
Ultimately, investments that dont beat cash have failed. Cash also
provides a safe haven for funds when markets are rocky or looking
overvalued. Some funds also trade in currencies to boost their
returns from cash when interest rates are low, like now.
These asset classes can behave very differently. There are times when
some will do well and others poorly. All of them are prone to occasional
bubbles and crashes, which makes it difficult to generalise too much.

VARIOUS TYPES OF ASSET ALLOCATION

In the uncertain world of finance, we know that systematic investment


and sticking to your asset allocation hold the key to success. But
wealth management experts use asset allocation strategies not only to
create wealth, but also to protect it during volatile times. It is not
the maximisation of returns, but optimisation of returns that becomes the
goal of money managers. Asset allocation strategy has to be
reviewed continuously. This process plays a key role in determining the
risk and return from your portfolio. Broadly speaking, the portfolios asset
mix should reflect your risk taking capacities and goals. Wealth managers
use different strategies of building asset allocations and we outline some
of them and examine their basic management approaches.

Strategic Asset Allocation

Strategic allocation is typically the first stage in the investment process.


Based on the investors long-term objectives, an initial portfolio is build. It
is the backbone of any investment strategy. This often forms the basic
framework of an investors portfolio. This is a proportional combination of
assets based on expected rates of return for each asset class. For
example, if stocks have historically given a return of 12% per year and
bonds have returned 6% per year, a mix of 50% stocks and 50%
bonds would be expected to return 9% per year. Strategic asset
allocation generally implies a buy-and-hold strategy. Strategic asset
allocation defines the boundary of risk, and it is these boundaries that
help control
portfolio risk.

Constant-Weighting Asset Allocation

Strategic asset allocation has its drawbacks as it entails a buy-and-


hold strategy even if a change in the value of assets causes a drift from

3
the initially established policy mix. This has driven the wealth managers
to resort to the constant weighting asset allocation. This strategy helps
you to continuously rebalance your portfolio. For example, if gold was
declining in value, you would purchase more of it to maintain its
weightage and if its value increased you would sell it. There are no hard-
and-fast rules for the timing of portfolio rebalancing under strategic or
constant-weighting asset allocation. Most wealth managers are of the
opinion that the portfolio should be rebalanced to its original mix when
any asset class moves more than 5-7% from its original value.

Tactical Asset Allocation

Over the long run, a strategic asset allocation strategy may


seem relatively rigid. There are investors who constantly want to seek
returns out of market opportunities that arise. Hence, investment
managers find it necessary to go in for short term tactical calls. Such
tactical calls create room for capitalisng on unusual or exceptional
investment opportunities. This is like timing the market to participate in
the fluctuations and volatility that arise due to market conditions. While a
strategic asset allocation is revisited once in six months, tactical asset
allocations are visited every month. Tactical calls are on an ongoing basis.
For example, shifting a part of the portfolio from large cap stocks to mid
cap stocks to take advantage of the environment is a tactical call. We
restrict our tactical calls around 10% of the total portfolio and rest of the
money is strictly governed by strategic allocation, said a wealth advisor
with a foreign wealth manager. Tactical allocations being opportunistic in
nature, wealth managers prefer to maintain clear time-based and value-
based entry and exit points to ensure better risk management.

Guided And Optimised Allocation

This can be seen as the advanced version of tactical asset allocation.


When tactical asset allocation aims to take advantage of temporary
situations in the market, the concept of guided and optimised allocation
believes in squeezing the last drop out at all times. By very nature, it is
meant for a bit aggressive investor. Here 75% of the clients portfolio
could follow the original asset allocation, while 25% of the portfolio will
explore opportunities where there could be chances of making higher
return. So, investing in gold futures for a quick buck, or short-term
corporate deposits offering higher rate of interest and such other
opportunities remains on investors lookout. Here you must continuously
stay tuned with the financial markets. The strategy further demands you
to take into account transaction costs as the investors turn hyper active in
search of higher returns.

Dynamic Asset Allocation

4
For aggressive investors who want to ride momentum at times,
managers recommend dynamic asset allocation. So, if the stock market is
showing weakness, you sell anticipating a further fall. If it is going up, you
buy anticipating a further rise. Here you constantly adjust the mix of
assets as markets rise and fall. This is the opposite of constant-weighting
strategy. As the entire portfolio is available for action, amateur investors
may turn hyper active. Especially in the high volatile times, acting on all
types of information can lead to high transaction costs. Also, the tax
treatment of the returns turns to disadvantages if you churn your portfolio
too much. In times of high volatility, when the markets may not move up
or down much, dynamic asset allocation is not advisable for nave
investors. Depending on the type of investor you are, asset allocation
could be active or passive. However investors should choose one keeping
in mind their age, long term goals and risk taking capacity in mind.

IMPORTANCE OF ASSET ALLOCATION


Spreading Risk:

The decision to invest or not to invest naturally carries with it some level
of risk. Investors must bear the risk that their investments will fall in value
or even become worthless. Investors must also bear the risk that their
investments will not perform as expected or as well as other investments.
Those who choose not to invest also bear risk.

Reducing Portfolio Volatility:

The asset class performance chart also illustrates just how hard it is to
identify in advance which asset classes will outperform or underperform in
any given year. Indeed, it is not uncommon for an asset class to be the
best performer one year and then a poor performer the next year. For

5
example, emerging markets was the top performer in 2007, the worst
performer in 2008, and then the best performer again in 2009.

Producing more consistent portfolio returns:

A well-diversified portfolio also tends to produce more consistent returns


over the long term because this type of portfolio is exposed to a wide
variety of asset classes and thus a wide variety of potential sources of
growth. Also, in a well-diversified portfolio the out-performing asset
classes tend to mitigate the under-performance in other asset categories.

Capital discipline for equity investing:

Those companies that deliver capital discipline around their own shares
see more value in returning cash to investors than in the outperformance
of alternative investment opportunities. Hence, we systematically screen
the relevant universe to identify those companies that meet our criteria
for share capital discipline. This will include share buybacks without the
use of increased gearing or debt, signifying that the capital return to
shareholders is derived from operational cashflow rather than financial
engineering.

Low dependence on a single asset for returns within an asset class

Not all assets within a single asset class e.g. equity, perform well at the same time. This is
what makes it important to choose different stocks and different categories of mutual funds,
e.g. large cap, value style and so forth, and allocate funds efficiently even within the same
category.

Protection from Market Turbulence

Anybody who has lived and invested though the sub-prime mortgage crisis knows that when
equity caused the ground to fall out from under our feet, debt and gold kept investors heads
above water. For those who had pure equity portfolios, it was a mistake they will likely never
make again. A well diversified i.e. a well allocated portfolio will afford you protection and
offer you growth even during times of volatility.

Freedom from timing the market

Consider timing a single asset classs market. Those investors who try to actively time the
equity markets can testify to its volatility. Now imagine timing the performance and market
movement across different asset classes. Investing without stress is not hard to achieve, if you
remove timing the market, or markets, and implement a disciplined strategy.

6
THE 10 PRINCIPLES OF ASSET ALLOCATION
Principles can be described as the beginning, the foundation, the source,
or the essence upon which things build and expand. They are important in
investing because they bring structure to your financial plan. There are 10
cornerstone principles of asset allocation and each one plays a vital role in
establishing and maintaining a truly optimal asset allocation. By practicing
these principles, you can build an appropriate portfolio for your situation.
Keep in mind that asset allocation does not ensure a profit or protect
against a loss.

Principle 1: Market Efficiency

Market efficiency is the golden principle of all asset allocation cornerstone


principles. Without some degree of market efficiency, we would not
employ asset allocation and would probably focus instead on security

7
selection. Fortunately, our financial markets are highly efficient and are
becoming even more so as information technology gets better with time.

Underlying asset allocation are two highly influential and well-known


investment concepts: modern portfolio theory and the efficient market
hypothesis.

Modern portfolio theory says that neither investors nor portfolio managers
should evaluate each investment on a stand-alone basis. They should
instead evaluate each investment based on its true ability to enhance the
overall risk-and-return trade-off profile of a portfolio. Moreover, modern
portfolio theory states that when an investor is faced with two
investments with identical expected returns, but different levels of risk,
that investor would be wise to select the investment that has the lower
risk.

The efficient market hypothesis, in a related way, says that security prices
are fair and reasonable because they fully reflect all available public and
nonpublic information that might affect them. As a result, it is the amount
of risk that investors are willing to accept that explains their real
investment performance over time.

Principle 2: Investor Risk Profile

Your optimal portfolio is designed based principally on your willingness,


ability, and need to tolerate risk. Consequently, once your risk tolerance is
determined, your optimal asset mix can then be established in order to
maximize your portfolios return potential. This concept is expressed as
the risk-and-return trade-off profile. Personal preferences toward risk
assumption play a vital role in determining your willingness to tolerate
risk. For example, two different investors with the same level of wealth
and the same specific goals and needs would each have a different
preference for assuming risk.

Your ability to tolerate risk is highly contingent on your investment time


horizon and level of wealth. Generally, the longer your investment time
horizon and the greater your level of wealth, the more risk you are able to
tolerate because people with longer time horizons and people with greater
levels of wealth have more room for error in achieving their specific goals
and needs.

Principle 3: Identifiable Financial Goals

Asset allocation is the strategy of dividing the assets within a portfolio


among the different asset classes, seeking to achieve the highest
expected total rate of return for the level of risk you are willing and able to
accept. As a result, knowing why you are investing and what you are
attempting to accomplish is the vital first step. You cannot hit a target you
are not aiming for.

8
When identifying your specific goals and needs, focus on quantifying and
prioritizing them. Simply saying you need enough money to fund a college
education or support yourself in retirement is much too ambiguous and
not especially intelligent. Identifying that you need $25,000 per year for
four years in tomorrows dollars or $75,000 per year in retirement
expressed in todays dollars is more appropriate. Lastly, when identifying
your specific goals and needs, ensure that they are realistic, achievable,
and measurable.

Principle 4: Time Horizon

Time horizon plays a significant role in estimating asset class returns, risk
levels, and price correlations. Accurate forecasts are essential to building
an optimal portfolio. The primary use of time horizon is to help determine
the portfolio balance between equity assets and fixed-income assets and
cash and equivalents. All else being equal, the longer your investment
time horizon, the more equity investments and less current income-
producing investments you may consider holding. Conversely, the shorter
your investment time horizon, the more current income-producing
investments and less equity investments you may consider.

One common risk that needs to be addressed over the long term is
purchasing power risk, or the loss of an assets real value due to inflation.
Equity investments may provide the best hedge against this risk. As a
result, the longer your investment time horizon, the more you may
consider allocating to equity assets. In the short term, volatility is often a
concern. Fixed-income investments may provide the best hedge against
this type of risk and may be considered in your portfolio as well.

Principle 5: Expected Total Return

Expected total return is simply your forecast of total return for each asset
class and asset subclass during the future holding period. While past
performance does not guarantee future results, using historical rates of
return in lieu of estimating expected rates is not only quick and easy but
also a prudent approach used by many financial professionals.

Once your risk tolerance has been identified, you then design your
portfolio to maximize your expected total rate of return for the given level
of risk you are willing, able, and need to assume. This task cannot be
accomplished without an estimate of future returns. This is the essence of
the risk-and-return trade-off profile. Without a clear understanding of
expected total rates of return for each asset class, there is little hope of
maximizing a portfolios potential performance and building your optimal
portfolio.

Principle 6: Risk-and-Return Trade-off Profile

The trade-off between investment-specific risk and return is central to the


application of asset allocation theory to an investment portfolio. Risk and

9
return are unequivocally linked, and one simply cannot earn an excessive
return while assuming a corresponding low risk. In basic asset allocation
theory, the higher your risk tolerance, the higher your potential returns.
You should not assume higher risk for the same potential return that a less
risky asset may offer. The message here is that you need to build a
portfolio with the maximum expected potential total rate of return given
the level of risk you are willing, able, and need to assume.

Principle 7: Correlation

The term correlation refers to how closely the market prices of two
investments, or, in the case of asset allocation, the prices of two asset
classes move in relation to each other. Although not always the case, most
securities within an asset class or asset subclass tend to move together
over time. Of course, there are always exceptions.

Your aim is to allocate investments to asset classes and asset subclasses


that do not move in perfect lockstep with each other. The greater the
difference or the lower the correlation that two asset classes move
together, the more attractive they are for investment purposes. Since
some asset classes experience strength at one time whereas others
experience strength at other times, it may be appropriate, depending on
your tolerance for risk, to allocate among multiple asset classes at all
times. Investing in multiple asset classes may allow you to avoid serious
market and portfolio weakness. Lastly, by investing in multiple asset
classes with low correlations, you enhance the risk-and-return trade-off
profile for your portfolio.

Principle 8: Diversification

It is important to apply the principle of diversification in order to minimize


risk in a portfolio. The task of diversifying a portfolio should be addressed
after completing the process of allocating among asset classes and asset
subclasses.

Diversification is the process of investing in a significant number of not-


too-similar investments within each asset class in an effort to reduce the
risk associated with each individual investment. By holding a significant
number of not-too-similar investments, the impact resulting from a
negative investment-specific event may be minimized. It is important to
understand that the process of diversification entails investing in a
significant number of not-too-similar investments with similarrisk-and-
return trade-off profiles. In doing so, your risk-and-return tradeoff profile
will remain constant. There is no guarantee that a diversified portfolio will
enhance overall returns or outperform a non-diversified portfolio.
Diversification does not protect against market risk.

Principle 9: Optimal Asset Mix

10
Asset mix refers to both the asset classes and asset subclasses that a
portfolio is allocated to and their respective weightings within that
portfolio. It is essential to allocate a portfolios assets in a deliberate and
calculated way in order to develop the desired risk-and-return trade-off
profile. Thus, allocating assets to those asset classes and asset subclasses
to develop the desired risk-and-return trade-off profile defines the optimal
asset mix.

Incorrectly allocating assets will create a situation where the portfolio


either assumes more risk than appropriate or does not assume enough
risk, thereby depriving you of better return potential. As you know, your
work does not stop once your portfolio is designed and built. Constant
monitoring and rebalancing will need to take place.

Principle 10: Reoptimization

Over time, a portfolios asset mix, including the resulting risk-and-return


trade-off profile, will change due to price fluctuations, with some
fluctuations being quite large. To address this issue, reoptimization may
be appropriate and needed. Reoptimization is comprised of four different,
but somewhat similar, tasks. Think of these tasks as the Four Rs of
Reoptimization: reevaluating, rebalancing, relocating, and reallocating.

Reevaluating is the task of examining recent changes in your life


and evaluating them within the context of your portfolio.

Rebalancing is the task of selling and buying investments in order to


return a portfolios current asset class mix to the previously
established optimal asset mix. Tax implications should be
considered when implementing a rebalancing strategy.

Relocating is the task of exchanging certain assets for other assets


without changing the overall asset mix or risk-and-return trade-off
profile.

Reallocating is the task of adjusting to which investments your


contributions go and in what amount. In this context, reallocating
does not change the mix of your assets, only how contributions will
be made in the future.

11