Managing investment risk through a sound asset allocation strategy can be effective
As risk drives return, investing and managing portfolios should focus primarily on managing risk rather than returns. A proven way to manage risk is through sound asset allocation — the process of deciding how to distribute an investor’s wealth among different asset classes.
An asset class comprises financial instruments with similar characteristics and risk-return relationships.
A broad asset class, say, bonds, can be divided into smaller asset classes such as government bonds, corporate bonds, and high-yield bonds.
Not done in isolation
An asset allocation decision is not an isolated choice — it is a component of the portfolio management process. Much of an asset allocation strategy depends on the investor’s policy statement, which includes their goals, constraints and investment guidelines. The term ‘investor’ can mean an individual, trustees overseeing a corporation’s multi-billion-dollar pension fund, a mutual fund, a university endowment or invested premiums for an insurance company. Irrespective of who the investor is, or how simple or complex the investment needs, one should develop a policy statement before making long-term investment decisions. The concepts discussed here apply to all investors — individual
Real vs financial assets
Real assets are value-generating properties and commodities. Essentially, they are physical items such as land, buildings and precious metals, which have intrinsic value — the exact value of an asset as determined by factors such as location, functionality and acquisition costs.
Some common categories of financial assets are equities, bonds and derivatives. Normally, financial assets are available through stock exchanges and do not require any physical holding per se. So, they represent legal claims on future financial benefits. These are no more than sheets of paper, or just an entry in your demat account.
Similarities and differences
Real and financial assets share a number of similarities. For instance, the valuations of both are based on their cash flow generating potential. As asset classes, both exhibit a significant degree of uncertainty while predicting cash flow trends.
Typically, the majority of financial assets are more liquid than real assets as they are easily convertible into cash. For instance, while it takes a few hours to sell stocks, the same is not feasible in case of real estate, which may take months to dispose of. Further, cash flows generated by financial assets experience perpetual growth. Real assets, with the exception of land, perpetually generate diminishing cash flows. The valuations of buildings, for instance, reduce over time owing to depreciation.
Making a choice
The decision of choosing between financial and real assets is made based on factors such as investor need, objectives, time horizon and risk appetite. Also, sometimes, one may have to buy financial assets to acquire a real asset. For example, if you plan to buy some real estate after three years, you can start investing your disposable income in financial assets with a view to acquire the real asset later on.
As mentioned earlier, each asset class works differently and must be selected keeping in view various parameters such as risk, the investment horizon and the quantum of returns expected. Investment vehicles such as bank fixed deposits and post office investments or government-backed bonds come under the low-risk investment category, offering assured returns after a specific period. The returns are not as high as those from slightly riskier investments, such as shares and mutual funds.
Though asset allocation should differ from person to person, the investor must factor their age, the quantum of income and disposable income available, investment horizon, risk tolerance and overall financial goals with reference to risk and return. Asset allocation is not a one-time process — the investor needs to monitor and factor in his needs and environmental conditions. The investor also needs to evaluate the performance of one’s portfolio
There are no shortcuts to successful investing — maintaining a disciplined approach increases the likelihood of success over a period of time. Asset allocation must always be balanced for holistic wealth creation.
Real road to financial glory
Real assets are value-generating properties and commodities. Essentially, they are physical items such as land, buildings and precious metals
Some common categories of financial assets are equities, bonds and derivatives. Normally, financial assets are available through stock exchanges and do not require any physical holding per se
Most financial assets are more liquid than real assets as they are easily convertible into cash
Cash flows generated by financial assets experience perpetual growth. Real assets, with the exception of land, generate perpetually diminishing cash flows
The decision of choosing between financial and real assets should be based on factors such as the investor’s goals, time horizon and risk appetite
The writer is associate professor of finance and accounting in IIM-Shillong