Every time when you speak to any wealth manager, they will discuss about having the right asset allocation. Investors generally do not give much importance to asset allocation. Is it really necessary?
Asset as a class may be grouped into Equity, Debt, Real Estate, Gold and Cash with each asset class having its unique risk, reward and liquidity profile. You cannot have your entire portfolio made of equity or debt or real estate or gold. One way to look at them would be comparing them with respect to risk and diversification characteristics – Risk, liquidity, and correlation.
Each asset class carries a particular risk. Equity has market risk, debt has credit risk and interest risk, real estate has liquidity risk. Within the asset classes there is sub classes. Equity is divided into large cap, mid cap and small cap. Debt is short term or long term, investing into different types of papers. Real estate may be commercial or residential.
You may be willing to bear higher risk only if the returns are higher, or you may be willing to take on risks, if there is no trade-off by way of higher return. Different risk profile necessitates your needs to allocate capital to different assets. The risks of various asset classes can be summarized as below:
|Equity||Real Estate||Bonds||Cash and cash equivalent|
|High risk||High risk||Medium risk||Low risk|
|High return||High return||Stable return||Low return|
|Growth oriented||Growth oriented||Income oriented||Income oriented|
|Highly liquid||Low Liquid||Low/ medium Liquid||Very High Liquid|
While constructing and managing an investment portfolio, the focus is always on generating a better risk-adjusted return. This means you will look out for asset classes that have a lower correlation with what you hold in the portfolio, so that you can achieve better returns at a lower risk. The extent to which risk is reduced by combining assets depends upon the ‘correlation’ between various asset class returns. Measuring correlation provides two kinds of information: whether the asset class returns are moving in the same or opposite direction over a long term and what is the extent to which they co-move.
If returns from investing in equity and debt move completely in tandem, going up and down together, there is no benefit of combining the two investments. However, if they moved in exactly opposite directions, an investor can achieve a risk level of zero by combining the two asset classes. This is because the gain on one will be exactly offset by the loss on other, so that there is no gain or loss on a net basis. In reality, he may not be able to achieve a zero risk portfolio, but can surely reduce the risk by bringing in assets that do not move in the same direction.
At different points in time different asset classes tend to perform well. All asset classes are impacted by economic cycles and their performance can vary significantly at different phases of the market cycle. A year that gives a positive return for investing in equity may have negative return for debt; if short term debt instruments performed well in one year, emerging market equity investments would do well in another. If various asset classes are ranked for their performance, it is unlikely to see the same asset class performing year after year. Investing across asset classes provides the benefit of diversifying risk. This is because asset classes in themselves may be risky, but since they are affected differently by different factors, they generally do not move together. They cancel out the risks of one another to some extent, creating a benefit of lower overall risk, called the diversification benefit. The fundamental principle in constructing a portfolio is to enhance the benefits of diversification.
A portfolio has to be flexible enough to meet different goals. An investor needs to provide for the emergency needs by keeping money in cash and cash equivalent even though the returns may be less. Real estate if largely illiquid and prone to liquidity risk and hence the same may not comprise of large portion of portfolio. Long term debt may not have ready market and are less liquid.
These factors make it imperative that there has to be proper asset allocation taking into consideration the risk profile of the investor and goals.
Indicative model portfolios for various profiles may be constructed describing return, risk andtime horizon attributes. Consider this illustrative example:
|Cash, FD, Cash equivalent||80%||45%||20%|
|Time Horizon||2-3 years||3-5 years||Atleast 5 years|
Asset allocation decisions have to be aligned to portfolio objectives, risk preference and time period for which the investor likes to hold the investment. It is very unlikely that a single asset class meets all the needs of an investor. Typically, an investor will have multiple requirements from the portfolio: growth for long-term goals, liquidity for immediate needs and regular pay outs to meet recurring expenses. A diverse portfolio of securities with exposure to different asset classes may be needed to be created in order to cater to these diverse needs. An asset’s own risk and return features are less important than how it works in combination with other assets in a portfolio. Hence, asset allocation is key to better risk adjusted return and goal based financial planning. There are personal financial planning tools which can assist you in this process.