What is Asset Allocation?
According to Investopedia "Asset Allocation means spreading your investments across various asset classes. Broadly speaking, that means a mix of stocks, bonds, and cash or money market securities."
Maximizing Return & Risk
The goal of allocating your assets is to minimize risk while meeting the level of return you expect. To achieve that goal, you need to know the risk-return characteristics of the various asset classes. The figure below compares the risk and potential return of some of them:
The rule of thumb is that an investor should gradually reduce risk exposure over the years, in order to reach retirement with a reasonable amount of money stashed in safe investments.
6 Golden rules of Asset Allocation
Well known studies by Brinson et.al. (1986, 1991) concluded that "More than 90 percent of the variation in a portfolio's performance over time is due to its asset allocation". The studies further assert "… investment policy dominates investment strategy (market timing and security selection)."
These findings have become the bedrock of financial planning discourses and have their fans and critics alike.
- Rules over views : Views are beliefs formed over time and involve predictions about markets. They are based on assumptions about future outcomes. These views differ depending on one’s ‘conditioning’ and may or may not hold true. However, an asset allocation plan based on ‘rules’ or some pre-determined scientific formula which uses actual parameters, is likely to triumph over views and market outlooks.
- Understanding Behavioural Biases : Investing is more behaviour than Math :Investment decisions are driven by biases and not necessarily facts. Empirical theories assumed that investors were rational beings and made economically sound decisions based on data. However psychologists who studied investment behaviour, realised that investors make decisions based on biases and emotions.
- Low correlation amongst Asset Classes is important : When constructing a portfolio is very important to look at the correlation of the asset classes. Investing in positively correlated asset classes, is not advisable as both asset classes are likely to deliver similar returns and will carry similar risks.
- Discipline to Rebalance weights systematically : Asset Allocation must never be at the mercy of ‘last one year returns’. With regular rebalancing across asset classes one can maximize the benefits of asset allocation.
- Risk Tolerance and not just age : Risk tolerance is a combination of various factors such as one’s income, liabilities, number of dependents, financial goals, need for cash flows, savings, and age.
- Taxation : Taxes are happy outcomes. In the obsession to avoid taxes – one may end up taking undue risks.
Risk Tolerance
Risk Tolerance is defined as the amount of risk the investor can tolerate before deciding to exit the market and usually depends on the investor’s financial situation, type, preference of asset class, time horizon, and purpose of investments.
An investor needs to have an understanding of risk tolerance; otherwise, they may see a large movement in the value of investment and panic, which might cause to sell at the wrong time.
Your risk tolerance is your ability and willingness to assume risk.
Your ability to assume risk is based on your asset base, your time horizon, and your liquidity needs.
In other words, your ability to take investment risks is limited by how much you have to invest, how long you have to invest it, and your need for your portfolio to provide cash—for use rather than reinvestment—in the meantime.
(Disclaimer : This blog is for information purposes only)
