We all know why a Swiss knife is way better than a simple knife – it can do many more things for you. So is the case with Asset Allocation in a portfolio. It enables the diversification of assets, the ensemble being such that it allows returns from various spheres, thereby not letting the
not-so-favourable performance of a particular asset affect the rest of your portfolio returns.
A rare trait of financial planning, Asset Allocation revolves around the distribution of money (to be invested) across various investment avenues or assets. Asset Allocation forms the basis of investment strategy, as it is one of the only scientific ways of building the portfolio. Usually, nearly 90% of the returns of a portfolio come from its Asset Allocation model, as this clearly breaks away from the myth of timing the market!
With the able guidance of a financial planner, Asset Allocation can prove to be a highly effective tool. A financial planner is in the right position to gauge the investor’s risk profile based on a focused questionnaire indicative of the risk appetite, cash flows, return expectations, and the investor’s overall financial goals. This leads the investor and his/her financial planner to arrive at the degree of risk that can be taken and thereby evolves a risk matrix.
What’s even more interesting is that the process of Asset Allocation is a dynamic one. It involves Strategic Allocation based on the kind of risk appetite – conservative, moderate or aggressive – the investor has. Asset Allocation is largely done on this basis across asset classes. However, it has two additional approaches that need to be understood – Re-balancing and Tactical Allocation.
Re-balancing is a disciplined method that depends on market movements. It evaluates the portfolio with respect to the directional shifts in the market, thereby reviewing the constitution of the portfolio and reverting to the mean asset allocation, allowing a +/- 10% deviation. Re-balancing ensures that one sticks to the pre-determined Asset Allocation plan and that the investment remains within the fine boundaries of the investor’s risk profile.
Tactical Allocation stems from a different standpoint as it is a temporary strategy based on investment view. It centres on altering investment proportions to take advantage of market inefficiencies causing differences in expected performance of various asset classes. Herein, the expected performance of broad asset classes is evaluated over a medium term, unlike the ordinary retail investor’s approach of attempting to predict which individual assets are likely to rally next. Usually, Tactical Asset Allocation allows a +/- 20% deviation from the mean, and is predominantly focused on the equity asset class.
Overall, asset allocation is a good bet to counter market uncertainties because firstly the pay-off is much better over the longer term. Secondly, it provides consistent returns, which is every investor’s natural lookout. Thirdly, it reduces the volatility effect on the portfolio which makes it highly suited to the investor. Thus, Asset Allocation helps the portfolio to perform consistently, irrespective of which asset class is likely to perform well during which period, so as to minimize volatility.
One of the primary advantages of Asset Allocation is that it allows setting of a definite and traceable benchmark. For example, if the equity benchmark has seen a return of about 15% for the year, and the debt benchmark of about 8%, a 60:40 Equity: Debt portfolio should be expected to provide a weighted average return of 10.2%. While analyzing the impact of investment decisions on portfolio returns, one can look at this blended benchmark return number to judge if the portfolio has done well. This blended benchmark return can, of course, be achieved or beaten only if the asset allocation of 60:40 is followed as agreed upon. If there are too many deviations from the same, the portfolio could be chasing trends arbitrarily leading to an end state that is far from desirable.
All in all, Asset Allocation cannot be followed in an ad hoc fashion. It is a disciplined strategy and forms the pillar of investment. Once incorporated, its impact is significant to the portfolio and beneficial to the overall financial planning and as it dots the landscape of an investor’s financial goals.
Disclaimer: The views expressed in the articles are personal of the authors and do not reflect the views of Kotak Mahindra Bank Ltd.