Research & Insights

Strategic Asset allocation

Asset allocation is the process of spreading your investments among different asset classes such as stocks, bonds, Real estate and short-term investments like bank deposits. The process of determining ideal mix of assets to hold in your portfolio is called Strategic Asset Allocation.

Establishing a well-diversified portfolio may allow you to avoid the risks associated with putting all your eggs in one basket.It is also the key for long-term wealth creation.

Why is Asset Allocation Important?

Historically, the returns of the major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. 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 is risky. Asset allocation can help mitigate the risk and volatility in your portfolio. However, it does not ensure a profit or guarantee against loss.

Asset allocation decisions involve tradeoffs among the following factors.

  • Risk appetite
  • Return expectations
  • Time horizon
  • Tax constraints
  • Liquidity requirements
  • Legal factors
  • Any other unique constraints

Depending on your age, lifestyle and family commitments, your financial goals will vary. You need to define your investment objectives — buying a house, paying for your children’s education or retirement needs for self. Besides defining your objectives, you also need to consider the amount of risk you can tolerate. Learning how to balance your comfort level with risk against your time horizon

For example, after retirement you might want to have higher exposure towards bonds and cash for regular income and greater stability. On the other hand, if you won't need your money for the next 10 years and are comfortable with the ups and downs of the stock market, you might consider a higher exposure to equity.

Maximizing Return While Minimizing Risk

The main goal of allocating your assets among various asset classes is to maximize return for your chosen level of risk, or stated another way, to minimize risk given a certain expected level of return. To maximize return and minimize risk, you need to know the risk-return characteristics of the various asset classes. The graph below compares the risk and potential return of some of the more popular ones:

assets

Equities have the highest potential return, but also the highest risk. On the other hand, Treasury bills have the lowest risk since they are backed by the government and they provide the lowest potential return.

The graph also demonstrates that when you choose investments with higher risk, your expected returns also increases proportionately. However, this is simply the result of the risk-return tradeoff. High return yielding investments will often have high volatility and are therefore suited for investors who have a high risk tolerance, and also they should have a longer time horizon.

It is because of the risk-return tradeoff that diversification through asset allocation is important. Since different assets have varying risks and experience different market fluctuations, proper asset allocation insulates your entire portfolio from the ups and downs of one single class of asset. A part of your portfolio may contain more volatile securities - which you've chosen for their potential of higher returns - the other part of your portfolio devoted to other assets remains stable. Because of the protection this stable asset offers, asset allocation is the key to maximizing returns while minimizing risk.

Choosing the right asset allocation

Your risk tolerance, investment objectives, time horizon, available capital and the other factors discussed above will provide the basis for the asset composition of your portfolio.
To make the asset allocation process easier for clients, many wealth managers create a series of model portfolios, each comprising different proportions of asset classes. These portfolios of different proportions satisfy a particular level of investor risk tolerance. In general, these model portfolios range from conservative to aggressive:

Equity and debt are the two broad classifications of asset classes.

The proportion of equity and debt in the portfolio varies according to your risk appetite. Equity exposure is usually the highest for aggressive investors and the lowest for conservative investors.

Conservative investors look at capital protection as their primary goal whereas, aggressive investors look at capital appreciation as their primary goal.

Let us look at the suggested exposure to equity and debt based on the risk appetites of investors.

asset

Review your asset allocation periodically

Asset allocation is very dynamic in nature; it is not a onetime process. It needs to be reviewed periodically to reallocate according to the changing financial goals and market conditions. A financial advisor can provide you the expertise in determining the best way to allocate your assets.