Asset Allocation Strategies and the factors that influence Asset Allocation:
More often people talk about investment planning to meet their financial goals. However, investment planning not just involves identifying financial goals and outlining an investment plan; there is another important component which if ignored can prove fatal to investment portfolio i.e. Asset Allocation.
What is an Asset Allocation?
Asset Allocation in simple words means investing or distributing your money across various asset classes such as stocks, bonds, cash, etc. thereby diversifying your portfolio. Diversification helps you to offset the risk associated with the poor performance of one asset thereby balancing it through another asset in your portfolio and is quantified through correlation. If there is a high correlation between the holdings in your portfolio, then your portfolio is not actually diversified and you need to change the portfolio composition to offset the market risk.
Not all asset class performs in the same way at the same time. For instance, if equities are facing a downturn it’s not necessary that another asset class such as debt is also under-performing. It also implies there is least correlation between the two asset classes. This is where the concept of asset allocation comes into picture and protects you from adverse economic conditions. Also, the returns from diversification may not be as high as the returns achieved by investing in one asset class.
The primary objective behind asset allocation is based on the adage “do not put all your eggs in one basket” according to Modern Portfolio Theory (MPT), if an investor wants to maximise the returns for a given level of risk, it’s prudent to invest in multiple asset class rather than putting all your money in one. Asset allocation helps you in determining which asset to buy and in what proportion.
Factors to consider for Asset Allocation
1. Age: If you are in the age of 20-30, you can afford to take high risk and may consider allocating a major portion of your portfolio into equities. If you are in the mid age i.e. between 30-55, you should have a diversified portfolio with moderate risk i.e. along with equity you should also invest in some other asset classes such as debt or fixed income instruments. However, if you are approaching your retirement, it’s advisable to have a conservative portfolio comprising of debt or fixed income instruments to safeguard the principle amount.
2. Income: The amount you invest is a function of the income you generate. An increase in your income will result in the increase of your investible surplus. The frequency and growth potential of your income also play a role in choosing the assets .
3. Time Horizon: Depending on how soon you want to meet your financial goals, you can decide on choosing various asset classes. For instance, for a long term goal like retirement which could be 20 years away, consider investing more in equities and less in debt or fixed income instruments. On the other hand, if you are looking to invest for shorter time horizon i.e. up to 3 years, you could choose to invest in debt or fixed income instruments.
4. Risk Tolerance: Your willingness as well as the ability to take risk is a function of the points mentioned above and plays a crucial role in designing your portfolio. If you are willing to take high risk, you can choose to keep a larger chunk of your portfolio in riskier assets. However, if you want to minimise the risk, you can opt to put larger chunk of your money in debt or fixed income instruments.
Benefits of Asset Allocation
• Lower risk: By diversifying your portfolio, you lower the risk by distributing it to multiple asset classes.
• Enhanced opportunity for market gains: Through multiple asset classes, you may lessen the impact of nonperforming asset categories, and improve your chances of participating in market gains.
• Increased goal orientation: A well allocated portfolio helps in reducing the need for constant monitoring of investment positions, thereby further reducing the need of buying or selling in response to the market’s short-term ups and downs.
Asset Allocation Strategies
Strategic Asset Allocation
Strategic asset allocation aims at creating an asset mix that provides the proportionate balance between expected risks and returns over long-term. In this, the investors typically pick few stocks and then offset it with a certain proportion of bonds, suitable to their risk tolerance. The idea is to offset risk from stocks by adding safer instruments like bonds or cash equivalents. The desired allocation depends on the factors such as age, risk tolerance, investment objective, time horizon, etc.
Strategic asset allocation benefits from regular rebalancing. Rebalancing your portfolio once a year helps you to minimise the risk of deviation from the desired target. Over a period, either stocks or bonds may outperform each other creating an imbalance in your portfolio. Rebalancing back to your target will help you in making a profit by selling high and reinvesting it in the asset which is lagging, therefore buying low.
Let’s understand this with an example:
Suppose Mr. Ramesh has Rs. 10,000,00 in his portfolio and the target asset allocation is 40% equities, 40% debt and 20% cash. The amount in equities will be Rs. 400,000, debt will be Rs. 400,000 and cash will be Rs. 200,000. Now, one year down the line, equities have grown by 10%, debt by 5% and cash by 5%, as a result the new composition will be: equities- Rs. 440,000, debt- Rs. 420,000 and cash- Rs. 210,000. The overall portfolio’s value is Rs. 10,70,000.
According to the target allocation, the portfolio value of Rs. 10,70,000 will now be allocated as: equities- Rs. 428,000, debt- Rs. 428,000 and cash- Rs. 214,000.
The table illustrated below will help you to understand the adjustment done to bring back the portfolio to its target allocation:
From the above table, you can see equities worth Rs. 12,000 has to be sold to bring it to the target allocation. Similarly, debt instruments worth Rs. 8,000 have to be bought, and cash has to be raised by Rs. 4,000 to bring the debt and cash component to the target allocation.
Tactical Asset Allocation
A Strategic asset allocation seems relatively immutable over the long run. You may find the need to engage in short-term, tactical deviations from the mix to capitalise on the current investment opportunities.
Tactical asset allocation allows you to actively manage your portfolio that helps you to capitalise on the possibilities in the short-term run. This strategy adds the market timing component to the portfolio, allowing you to take the advantage of the economic conditions which are more apt to one asset class over the other. Tactical asset allocation is often designated as a moderately active strategy, as the investors return to the original strategic asset mix, once the desired short-term profits are achieved.
Suppose Mr. Ramesh has Rs. 10,000,00 in his portfolio and the Strategic asset allocation is equity- 40%, debt- 40% and cash- 20%.
As a result of the upward movement in the equity market, Mr. Ramesh changes the asset allocation by moving the funds from debt to equity and increasing the allocation in equities. Now the new composition as per the Tactical asset allocation is equities- 45%, debt- 35% and cash- 20%. This is just to take the advantage of economic conditions. Mr. Ramesh will switch back to the original composition i.e. Strategic asset allocation when the market takes the U-turn.
Insured Asset Allocation
In Insured asset allocation strategy, you establish a base portfolio value below which the portfolio is not allowed to drop. Until the time portfolio’s return is above its base value, you can actively manage the portfolio and try increasing the portfolio’s value as much as possible. If in case, the portfolio’s value drops to the base value, you may invest in risk-free assets to fix the base value.
Insured asset allocation is suitable for risk-averse investors who desire an actively managed portfolio along with creating a secured benchmark below which the portfolio should not decline.
Core-Satellite Asset Allocation
Last but not the least, Core-Satellite asset allocation strategy is a hybrid of both the Strategic and Tactical allocations. In this strategy, your portfolio is made up of two components:
1. Core allocation includes stocks, bonds, or index funds forming the bulk of your portfolio. It is a strategic component which uses the offsetting risk strategies mentioned above. The core of your portfolio consists of anywhere between 50-80% of the total portfolio.
2. The remaining part of your portfolio is satellite allocation which follows more of a tactical approach. While your core holdings form the bulk of your portfolio and won’t alter much with time, your tactical component will allow you to capitalise on the opportunities in the market.
According to a study by Vanguard investments, effectively designed Core-Satellite portfolios will take the following factors into consideration:
• Establish the strategic asset allocation and risk profiles.
• Find out the asset class for core allocation.
• Find out the size of the core versus satellite allocation in each asset class.
• Find out the number of active satellites to be used and the one which is going to support the core.
This strategy is useful for the investors who want to be actively involved with their investments.
Choosing an asset allocation strategy depends on various factors such as investor’s age, income, time horizon, risk tolerance, etc. The process may be active in nature or exclusively passive. However, an allocation strategy that involves active participation in line with the market movements necessitates an expertise for timing these movements.