Asset Allocation and Investment Strategy

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Hellow and welcome to this lesson on Asset Allocation and Investment Strategy.

Investments are always made based on the Risk and Return criteria.

Different investment options that carry similar risk and returns are groupted together.

The grouping is done such that they respond in a similar manner to different economic and market events.

This is called an Asset Class.

Broadly speaking, there are three asset classes.

1. Equity

2. Debt

3. Cash

Equity Asset Class gives good returns but carries good amount of risk and takes high amount of time.

It is a growth oriented asset class.

It gives part-ownership of the investment.

The returns are usually proportional to the performance of the company.

Returns are possible only when the company makes profits.

The value of this asset class comes over a long period of time.

Equity asset class responds quicky.

Debt Asset Class gives stable returns with relatively lower degree of risk.

The rate of return is usually fixed and is pre-determined.

Debt is an income-oriented asset class.

Returns are gradual, usually periodic and in the form of regular stream of income.

When an investment is made in a debt instrument, we become lender to the issuer.

Lenders get intrest irrespective of the profits of the company.

Debt asset class responds slowly and gradually.

Cash is a liquid asset class.

It is used for parking funds for short periods.

There is almost negligible risk by holding in cash.

Each asset type has its own advantages and disadvantages.

We need to know about the characteristics of:

1. Cash
2. Bonds
3. Stocks
4. Real Estate
5. Gold and other precious metals
6. Alternative Investment Funds

Because of varied degree of risks and returns, investors have the choise of investing in such asset class that suits them.

Hence, it is always important that investors select the asset class according to his/her own risk appetite.

Each asset class can be sub-divided further.

For example, bonds can be divided based on credit risk (no credit risk with G-Sec vs credit risk as in the case of corporate bonds).

They can also be divided based on duration (short-term vs long-term)

Equity asset class can be categorized based on market capitalization, industry etc.

Asset Allocation

Asset Allocation is the process of:

Constructing a portfolio

With a mix of different asset classes

Keeping in mind the growth, income and liquidity needs of the investor.

Asset Allocation decides the future income and cash flows for the investor.

Hence, it is best designed keeping in mind the financial goals of the investor.

Investing in one single class so that it will outperform all the other asset class is not a good idea and often proves to be risky.

Hence, Asset-class diversification helps reduce if not eliminate risk.

Diversification helps meet investors expectations in terms of risk and possible returns.

Portfolio Construction

Asset Allocation Linked to Financial Goals

In this process, investor sets a financial goal.

He sets a monetary value he would need in future.

The future date on which the money is needed is determined.

Inflation rate is assumed and is taken into calculations.

According to this data, the asset allocation has to be determined.

Asset allocation depends on steps such as:

1. Assesment of individuals risk profile

2. Assesment if individual needs (resources to be matched too)

3. Arrival at the recommendation

Asset Allocation Linked to Life Cycle Stages

This involves using age of the investor as the criteria to decide between debt and equity.

Debt allocation = Age of investor

There are five stages to be considered

1. Childhood Stage
2. Young Investor
3. Young Couple in Mid 30’s
4. Mature Couple with grown up children
5. Retired Couple

Portfolio Objectives and Constraints

Both objectives and constraints of the investor are to be taken into consideration in portfolio design.

Asset classes like equity and real estate provide long term growth but come with short term volatility.

The allocation between growth and income depends on the investor needs, and therefore, portfolio return is driven by the financial goals of the investor.

In simple terms:

Portfolio cannot be designed only based on objectives or only based on returns.

Risk tolerance of the investor is one of the constraint.

Risk tolerance has two faces: Willingness to face risk and the ability to take risk.

Asset Allocation and Rebalancing Strategies

Strategic Asset Allocation (SSA)

This is a method by which asset allocation is done solely based on investor needs.

The allocation will depend on investor objectives and constraints.

Rebalance them periodically.

Restore the proportions by adjusting the asset classes.

Example

Initially: Asset allocation had 60% debt and 40% equity

Equity market performed well.

So the asset allocation will have 50% debt and 50% equity

Periodically, this has to be rebalaned

i.e part of equity is to be booked and the money be moved to debt

Such that the initial levels of 60% debt and 40% equity are maintained.

SSA has both advantages and disadvantages.

For example, SSA will underperform in bull runs.

It involves removing money from winning asset class and rewarding the losting asset class.

Tactical Asset Allocation (TTA)

Involves market timing as a decision factor.

The ultimate object is to outperform.

To do this, portfolio is rebalanced based on a view about the relative performance of asset classes.

This is an active management strategy.

Involves making short term adjustments in asset allocation for relative asset class performance.

Ex - a particular asset class is known to be giving more return in the next 2 or 3 months, you will rebalance ur portfolio accordingly.

This needs more involvement than the SAA

This rebalancing happens at 3 levels.

1. Individual rebalancing (the investor doing it by himself)
2. Advisors recommendations
3. Product provider such as MF manager rebalancing

Dynamic Asset Allocation (DDA)

This is algorithm or trigger based allocation during emergencies of unforeseen situations.

DAA works on a prespecified model which does a mechanical rebalancing between asset classes

Allocation doesn’t happen in fixed percentages. It always depends on the performance of the variables.

Ex - trigger option to shift to debt from equities at a certain high level of market index

Model Portfolios

3 things to consider for building a portfolio - Goals + time horizon + risk taking ability

Young investors have long time frame and can be willing to take risk

Old investors might not be willing to take risk and will have imited investing horizon and high dependence on investment income.

And one has to consider the need hierarchy before doing this.

Most important thing is to provide for the basic necessities of life (survival needs). Secondly provide for the contingencies and thirdly seek investment and returns

Divided into:

1. Conservative
2. Moderate
3. Aggressive

Portfolio Monitoring and Re-balancing

Investors can rebalance their portfolios based either on

1. the calendar
2. or on the basis of performance of the investments
3. only when the relative weight of an asset class increases or decreases more than a certain percentage that the investor has identified in advance
4. on need basis

Rebalancing tends to work best when done on a periodic but relatively infrequent basis.

Portfolios doesnt need too frequent rebalncing if they are planned and built carefully. Infrequent balances would more than suffice.

Three ways:

1. Investor can sell off investments from over-weighted asset categories and use the proceeds to purchase investments of under-weighted asset categories.
2. Investor can purchase new investments of under-weighted asset categories.
3. If investor is making continuous contributions to the portfolio, he can alter the contributions so that more investments go to under-weighted asset categories until the portfolio is back into balance.

As each person has a different financial need, each portfolio must be different. The attached is what i created for myself today, after reading the chapter.

One can put all the current asset classes and then fix a future date by which we can plan the rebalancing.

Questions

1. Which asset class should u consider to generate regular income? Equity Debt Cash

Answer: Debt

2. Portfolio of a young investor who is dynamic and wants to build a huge corpus should concentrate on? Debt Cash Equities Mutual funds

Answer: Equities + MF

3. If i want to rebalance my portfolio myself as i see an opportunity in small caps, what kind of asset allocation would that be? Strategic Tactical Dynamic

Tactical because he is "seeing an opportunity"

4. What falls between Conservative and Aggressive?

Answer: Moderate

5. What is the primary objective of Real Estate asset class?

Income or Growth?

Answer: Growth

6. What is the primary investment objective of long term bonds?

Income or Growth?

7. Which asset class / instruments are best as emergency fund?

Cash and money market securities (Liquid / Ultrashort term), as they are highly liquid and capital is preserved.

8. According to Life Stage Model, how much should be the debt allocation for a person whose age is 55 years?

Answer: 55

Answer is 55. Debt allocation = Age of investor

9. The construction of the portfolio involves allocating money to various asset classes is called _____

Asset Allocation

I know you are sleepy..

Last Questions

Ready?

10. Investment in art/collectibles is a type of alternative investment / assets.

True or False?

True

Related Lessons

• Investment Adviser and Regulatory Environment
• Bank Deposits (Banks, Post Office etc.)
• Introduction to Insurance
• Pre and Post Retirement Financial Planning

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