final asset allocation

8/8/2019 Final Asset Allocation

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Investment Planning

(Asset Allocation -

Concepts & Practices)

MAHENDRA K PATIDAR

PGDMBIF

Institute of Public Enterprise, Hyderabad


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Super Classes of Assets

Capital Assets

Assets that can be used as Economic

Inputs

Assets that are a store of value

Real Estate


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Capital Assets

Capital assets are defined by their claim on the future

cash flows of an enterprise. They provide a source of

ongoing value. These assets are usually valued as the

net present value of their expected returns. Besides stocks and bonds, PE funds, Hedge Funds and

Credit Derivatives belong to this category/ class of

assets.

PE funds and Hedge Funds are different from the

traditional stock- and-bond investments only because ofthe trading strategy they use, is different.

Mutual Funds, Exchange Traded Funds also belong to

this super asset class


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Assets that can be used as

Economic Inputs These are consumable or transferable assets which can

be converted to another form of asset.

Generally, this class of asset consists of physical

commodities, grains and metals etc. These assets are used as economic inputs to produce

other assets, like automobiles, appliances, new homesetc

These assets can not be valued using a net presentvalue computation as they do not produce a stream of

cash flow there may not be any capital appreciationalso.

This class of asset, however offer excellent diversificationopportunity, vis--vis capital assets.


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Assets that are a Store of

Value Art is considered the classic asset that store value. It

does not belong to the two classes of assets discussedearlier. Art requires ownership and possession. Its value

can only be realized throu

gh sale and transfer ofpossession. Antics also belong to this class of assets.

There is no rational way to gauge whether the price of anart would increase or decrease because its value isderived purely from subjective ( and private) visualenjoyment that the right of ownership conveys.

Gold and precious metals are another example of a storeof value class of asset. In developing countries theseassets are used to maintain wealth as they do not haveadequate access to other forms of financial assets.


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However the dividing line can

become blurred Gold can be used by jewelry manufacturers

Art pieces can be leased to star hotels for

decoration to generate a stream of cash flow(lease rentals)


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Real Estates

Real estate is a distinct class of asset.

It was a major asset class for most individuals even

before stocks and bonds came into existence.

For most individual investors, even today, real estates is

a major class of asset.

It is therefore known as a Fundamental Asset Class that

should be included within every diversified portfolio.


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What are Alternative Assets?

Alternative assets are just alternative

investments within an existing class.

They may employ alternative investmentstrategies like Hedge Funds and P E

Funds.

Four major alternative assets are :

Hedge Funds, PE Funds, Commodity

Futures and Credit Derivatives


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Asset Allocation

Asset Allocation is generally defined as

the allocation of an investors portfolio

across a number of asset classes. It is an investment profile that provides a

framework for constructing a portfolio

based on measures of risks and return.


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Asset Allocation Concepts

Asset Classes and Asset Allocation

Strategic vs. Tactical Allocation

Efficient vs. Inefficient Asset Classes

Asset Location vs. Trading Strategy


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Asset Classes & Asset

Allocation Traditionally asset allocation involved four classes of

assets: Equity, Fixed Income, Cash and Real Estate.

Within each class, the assets could further be divided into

subclasses. For example Stocks can be divided intolarge-cap, mid-cap, small cap stocks, Fixed income

Securities can be divided into Treasury Bills, Bonds,

Bank Fixed Deposits etc.


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Efficient vs. Inefficient Asset

Classes Stock and bond markets are generally considered to be

efficient, though the degree of efficiency vary. Efficiency

is a parameter which measures to what extent all the

publicly available information about a corporation foundreflection in price of its securities.

In contrast, with respect to alternative assets, information

is very difficult to acquire. Most alternative assets are

privately traded. Investment in alternative assets are less

liqu

id.


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Asset Location vs. Trading

Strategy Economic exposure( risk and return) associated with

mutual funds is defined primarily by where the mutual

fund invests, viz., mid-cap fund, infrastructure fund,

diversified equity fund etc. In contrast to this, hedge funds economic exposures are

defined more by how they trade. That is, a hedge funds

risk and return exposure is defined more by a trading

strategy within an asset class than it is defined by the

location of the asset class.


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A Guide to Portfolio

Construction In today's financial marketplace, a well-

maintained portfolio is vital to investor's successAs an investor, one need to know how to

determine an asset allocation that bestconforms to his / her personal investment goalsand strategies.

As an individual, your portfolio should meetyour future needs for capital and give you

peace of mind.

Construction of portfolio must take into accounteffects of risk return trade off .


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Factors to be considered for

Portfolio Construction Age

Family Status

Capital Available

Time left for Accumulation

Future Capital Needs Expected

Returns Risk Profile Risk Tolerance

Available Asset Classes


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Diversification of Portfolio as a

measure for reducing Risk Diversification can eliminate most, if not all , of the

nonsystematic / specific risks of individual securities, leaving the

portfolio with only market related risk.

However, one observes a diminishing marginal diversificationeffect through the addition of new securities to the portfolio.

Fund managers tend to have a minimum of 15 stocks in their

portfolio, but hold more securities if the overall value of fund

size is higher.

Certainly by the time 15 stocks have been included, a very

great portion of specific risks of individual securities have beendiversified away as a result of differing behavior of securities

given different market conditions.

Alternative assets are used for effective diversification of a

portfolio


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Diversification Effect

Expected Portfolio Variance

Number ofSecurities

6 12 18 24 30


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Steps for Portfolio

Construction Consider all the factors for portfolio construction ( age etc.)

Decide all the asset classes and subclasses which should find aplace in the portfolio.

ForStocks, decide Sector wise Market-cap limits

For bonds, decide share of Government & Corporate Bonds

Decide Stock Picking & Bond picking Strategies

Decide on shares of Mutual funds and Exchange Traded Fundsand their picking strategies

Decide on other fundamental and alternative assets

Arrange for contingencies Cash or near cash instruments Balance the portfolio by fixing weightages

Rebalance from time to time to get better results ( risk-returnprofile)


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Risk Return Profile of Assets

Risk

Small-cap

Mid-cap

Large-Cap

Corporate Bonds

Government Securities

Return


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Risk Pyramid

Summit options High Risk

futures

Middle Real Estates

Equity Mutual Fund

Large, Mid &Small Cap

High Yielding Bonds / Debts

Base Government Bonds / Debts

Money Market, Bank Deposits

Cash & Cash Equivalents Low Risk


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Risk Pyramid

Base of the Pyramid The foundation of the pyramid represents the

strongest portion, which supports everything above it. This area should

be comprised of investments that are low in risk and have foreseeable

returns. It is the largest area and composes the bulk of your assets.

Middle Portion This area should be made up of medium-riskinvestments that offer a stable return while still allowing for capital

appreciation. Although more risky than the assets creating the base,

these investments should still be relatively safe.

Summit Reserved specifically for high-risk investments, this is the

smallest area of the pyramid (portfolio) and should be made up of

money you can lose without any serious repercussions. Furthermore,

money in the summit should be fairly disposable so that you don't have

to sell prematurely in instances where there are capital losses.


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Matching Risk Tolerance to

Personality Having a good understanding of an investor's risk tolerance is crucial to

any successful advisor/client relationship. It is also a key component of

any good investment policy statement. Investment advisors usually

explore things like age, size of investment portfolio, expected retirement

date and future earnings and financial obligations to gauge an investor'srisk tolerance. These quantifiable aspects can tell us a lot about an

investor's abilityto take investment risk, but what about his/her

willingness? Personality profiling can help facilitate discussions with

investors about risk tolerance and can give one insight into investment

strategies that may fit their psychological profile. The first step in

personality typing is to understand the investor's personal background.

Interviewing an investor about their life experiences, inheritedbehavioural traits, career paths, and their current investment portfolio

can tell a lot about their willingness to take risk and whether or not they

have a tendency to make emotional decisions regarding their

investments.


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Personality Lower Willingness to Take Risk

Cautious investors make decisions based primarily on feelings and are

very sensitive to investment losses. Fear drives their investment

decision making process. They have trouble making proactive decisions

regarding their investments and do not trust the advice of others. Forthis reason, their portfolios usually have low turnover and include mostly

safe investments. Possible examples of investors that tend to have

cautious personalities might include retired elementary school teachers

and elderly widows.

Methodical investors follow a disciplined, mechanical investing strategy.

They make investment decisions based on hard facts and have the

tendency to nitpick about small details. They rely heavily on investmentresearch and are not emotional about their investment decisions. They

tend to be disciplined investors which can cause them to have a lower

risk tolerance. Possible examples of investors that tend to have

methodical personalities could include architects and engineers.


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Matching Risk Tolerance To

Personality Higher Willingness to Take Risk

Spontaneous investors make investment decisions based on feelings

and make them frequently. They are always second guessing

themselves and the advice of others and often chase investment fads.

For this reason, their investment portfolios usually exhibit high portfolioturnoverand may include riskier investments. Possible examples of

investors that tend to have spontaneous personalities might include a

commission-based salesperson or a young trust fund heir.

Individualist investors make decisions based on hard facts and do not

second guess their investments often. They exercise independent

thinking and put a great deal of trust in their investment research. For

this reason, they are usually less risk averse than others. Individualistinvestors are usually self-made and hard working. Possible examples of

investors that tend to have individualist personalities could include a

small business owner or an upper level manager in a large corporation.


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Personality When dealing with individual investors, building a truly customized

investment portfolio involves a good understanding of both their ability

and willingness to take risk.


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What is the difference between risk

tolerance & risk capacity ? Risk tolerance and risk capacity together help to determine the amount

of risk that should be taken in a portfolio of investments.

Risk Tolerance

Risk tolerance is the amount of risk that an investor is comfortable

taking, or the degree ofuncertainty that an investor is able to handle.Risk tolerance often varies with age, income and financial goals. It can

be determined by many methods, including questionnaires designed to

reveal the level at which an investor can invest, but still be able to sleep

at night.

Risk Capacity

Risk capacity, unlike tolerance, is the amount of risk that the investor

"must" take in order to reach financial goals. The rate ofreturn necessary to reach these goals can be estimated by

examining time frames and income requirements. Then, rate of return

information can be used to help the investor decide upon the types of

investments to engage in and, the level of risk to take on.


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What is the difference between risk

tolerance & risk capacity ?

Balance of Risk

The problem many investors face is that their risk tolerance and

risk capacity are not the same. When the amount of necessary

risk exceeds the level the investor is comfortable taking, a

shortfall most often will occur when it comes to reaching future

goals. On the other hand, when risk tolerance is higher than

necessary, undue risk may be taken by the individual. Investors

such as these sometimes are referred to as risk lovers


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Risk Return Balancing-

Strategies


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Risk Return Balancing Strategy

Type of

Portfolio

Equity (%) Fixed Income

(%)

Cash &

Equivalent

Conservative 15-20 70-75 5-15

Moderately

Conservative

35-40 55-60 5-10

Moderately

Aggressive

50-55 35-40 5-10

Aggressive 65-70 20-25 5-10

Very

Aggressive

80-100 0-10 0-10


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Asset Allocation Strategies

Establishing an appropriate asset mix is a dynamic

process, and it plays a key role in determining portfolio's

overall risk and return. As such, portfolio's asset mix

should reflect ones goals at any point in time. There area few different strategies for establishing asset

allocations, and here we can outline some of them and

examine their basic management approaches.


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Strategic Asset Allocation

ConstantWeighing Asset Allocation

Tactical Asset Allocation

Dynamic Asset Allocation

Insured Asset Allocation

Integrated Asset Allocation


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Strategic Asset Allocation : Strategic asset allocation is a

method that establishes and adheres to what is a 'base policy

mix, which is maintained in the long run. It is a passive

strategy. It is a buy-and-hold strategy.

ConstantWeighing Asset Allocation :With this approach, you

continually rebalance your portfolio. For example, if one asset

were declining in value, you would purchase more of that asset,

and if that asset value should increase, you would sell it. There

are no hard-and-fast rules for the timing of portfolio rebalancing

under strategic or constant-weighting asset allocation. However,

a common rule of thumb is that the portfolio should be

rebalanced to its original mix when any given asset class moves

more than 5% from its original value.


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Tactical Asset Allocation: Over the long run, a strategic asset

allocation strategy may seem relatively rigid. Therefore, you

may find it necessary to occasionally engage in short-term,

tactical deviations from the mix in order to capitalize on unusual

or exceptional investment opportunities. This flexibility adds a

component ofmarket timing to the portfolio, allowing you to

participate in economic conditions that are more favourable for

one asset class than for others. Tactical asset allocation can be

described as a moderately active strategy, since the overall

strategic asset mix is returned to when desired short-term

profits are achieved. This strategy demands some discipline,as you must first be able to recognize when short-term

opportunities have run their course, and then rebalance the

portfolio to the long-term asset position.


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Dynamic Asset Allocation :Another active asset allocation strategy is

dynamic asset allocation, with which you constantly adjust the mix of

assets as markets rise and fall and the economy strengthens and

weakens.With this strategy you sell assets that are declining and

purchase assets that are increasing, making dynamic assetallocation the polar opposite of a constant-weighting strategy. For

example, if the stock market is showing weakness, you sell stocks in

anticipation of further decreases, and if the market is strong, you

purchase stocks in anticipation of continued market gains.

Insured Asset Allocation :With an insured asset allocation strategy, you

establish a base portfolio value under which the portfolio should not be

allowed to drop. As long as the portfolio achieves a return above itsbase, you exercise active management to try to increase the portfolio

value as much as possible. If, however, the portfolio should ever drop to

the base value, you invest in risk-free assets so that the base value

becomes fixed


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Integrated Asset Allocation:With integrated asset allocation you

consider both your economic expectations and your risk in

establishing an asset mix.While all of the above-mentioned

strategies take into account expectations for future market

returns, not all of the strategies account for investment risk

tolerance. Integrated asset allocation, on the other hand,

includes aspects of all strategies, accounting not only for

expectations but also actual changes in capital markets and

your risk tolerance.

Conclusion :Asset allocation can be an active process in

varying degrees or strictly passive in nature.Whether an

investor chooses a precise asset allocation strategy or a

combination of different strategies depends on that investor's

goals, age, market expectations and risk tolerance.


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Crux ofSuccessful Investment

Planning Matching the Tools and Strategies to the Personal Profile

of the Investor

Personal ProfileGoals, Expectation ofReturns, Risk Tolerance& Risk Capacity

Tools

Investment Vehicles

Strategies

Asset Allocation and

Trading Strategies


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Thank You

final asset allocation

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