Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon. It is the key for long term wealth creation. Asset allocation is based on the idea that in different years a different asset is the best-performing one. It is difficult to predict which asset will perform best in a given year. Thus, although it is psychologically appealing to try to predict the ‘best’ asset, proponents of asset allocation consider it risky.
Let us discuss various asset allocation strategies according to the time horizon, risk appetite and return expectations
Asset allocation based on time horizon
Assets protection for immediate needs
Protecting all assets from uncertainties would be the first priority in need-based asset allocation. It has two important factors – financial security and liquidity. The products which will fulfil the protection needs for financial security include health insurance, term life insurance, accident disability insurance and assets insurance. As far as liquidity is concerned, it is best to have at least three months of monthly expenses in liquid instruments like cash and bank savings account.
Assets preservation for medium term needs
Protection of capital would be the first priority for any medium term needs, say up to five years. Hence, the objective of the investor would be to get the best possible returns with principal protection which could be through bank fixed deposits, postal savings schemes, short/medium term mutual funds and bonds.
Assets accumulation for long term needs
This could be through:
Low risk – low return products such as Public provident fund/ Employees provident fund or traditional insurance policies (more than 70 per cent in debt)
Moderate risk – moderate return products such as gold, real estate and debt mutual funds
High risk – high return products such as equity mutual funds, unit linked insurance plans (more than 70 per cent equity) and equity shares
Asset allocation based on expected risk/return/liquidity
Risk – Risk means the quantifiable likelihood of loss or less-than-expected returns. A fundamental idea in finance is the relationship between risk and return. The greater the potential return one might seek, the greater the risk that one generally assumes. A free market reflects this principle in the pricing of an instrument.
Risk tolerance – Risk tolerance reflects the investor’s attitude towards risk. Risk tolerance is the ability and willingness to lose some or all of the original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favour investments that will preserve his or her original investment. Hence, we need to allocate assets according to investor psychology and expected risk/return/liquidity based on the historical data of the respective investments.
Return – Return is the primary motivating force that drives the investment. It represents the reward for undertaking investment. Since the game of investing is about returns (after allowing for risk), measurement of realised (historical) return is necessary to assess how well the investment instrument has done. In addition, historical returns are often used as an important input in estimating the future (prospective) returns.
Liquidity – Liquidity is the ability to convert an asset to cash quickly. Based on the investor’s liquidity requirements, he/she need to select the right investments. It can be classified as high liquidity, moderate liquidity, and low liquidity.
Asset Allocation Styles
Static asset allocation (buy-and-hold policy)
This policy advocates that the initial portfolio be left undisturbed. Irrespective of what happens to relative values, no rebalancing is done. In this approach, comprehensive analysis will be done before selecting the right mix of the various products. Consider a ratio of 60:40 of stocks and risk-free assets. As the stock market rises (or falls), stocks represent a larger (or smaller) weight in the portfolio and the risk-free asset provides a floor value. Returns are directly related to market performance in a linear relationship. When markets are in a bullish trend, buy-and-hold methods can perform well because the better-performing assets get increasingly larger weight and poor-performing assets have less impact.
Balanced asset allocation (constant mix policy)
A balanced asset allocation policy calls for a periodical rebalancing of the portfolio to bring back the portfolio to its original asset allocation mix. This is necessary because over time, some of the investor’s investments may not be aligned with their investment goals. It is common to find that that some investments will grow faster than others. By rebalancing, one will ensure that the portfolio does not overemphasize one or more asset categories, and the portfolio will return to a comfortable level of risk.
Constant-mix strategies can be characterised as contrarian as they sell the best-performing assets to buy the worst-performing. The shape of returns is concave – return increases at a decreasing rate in positive markets and decreases at an increasing rate in negative markets.
Dynamic asset allocation (Constant Proportion Portfolio Insurance policy)
This involves shifting the asset mix systematically in response to changing market conditions. This policy is the opposite of constant mix policy.
In strong bull markets, CPPI performs well by continually allocating more to stocks. In strong bear markets, CPPI avoids large losses by rapidly reducing the allocation to stocks. Such returns can be described as having a convex payoff curve as the return increases at an increasing rate when market returns are positive and decreases at a decreasing weight when market returns are negative.
When markets are characterised by frequent reversals, the constant changes in allocation result in high transaction costs that erode performance.
Conclusively, there is no asset allocation which will work at all times. Hence, investors need to select at least two asset allocation strategies according to their risk appetite and review the portfolio at regular intervals. Investor psychology towards the risk and return plays a vital role in selecting the right investment mix.