It was the Christmas evening in 2008 when two friends were repenting over the losses in their equity investments. Equities lost more than 20% that year dragging down the portfolios of both the friends.
It was the Christmas evening in 2008 when two friends were repenting over the losses in their equity investments. Equities lost more than 20% that year dragging down the portfolios of both the friends. They both believed that they understood the risk and were holding reasonably diversified equity portfolios of stocks and mutual funds representing various sectors to protect them against extreme volatility and losses. Little did they know that it is more important to diversify across asset classes rather than diversification within the asset class. A proper asset allocation consistent with their risk profile would have reduced their downside risk.
Process of asset allocation
The first step in the financial planning process is to know your risk profile and go for appropriate asset allocation with focus on accomplishing financial goals. Research shows that investors are extremely poor at timing and therefore, rather than enhancing portfolio, timing actually contributes negatively to the portfolio returns. Rather than focusing on asset allocation, an average investor spends disproportionate effort on timing and security selection within an asset class.
Now to simplify, let’s see what happens if we don’t distribute our investments in various asset classes. Suppose one invests 100% of the money into equity, then in the upward cycle he gets the full benefit of favourable winds, but during the downcycle he may face significant capital erosion. If one invests in fixed deposits to escape short-term volatility of risky asset class such as equity, then one may not be able to earn enough on a post-tax basis to beat inflation, leave alone fulfilling his financial goals.
Now if one knows which asset class is going to perform well in the next year, the choice is simple. But alas! Nobody can predict the future.
The asset allocation that does not depend on the forward looking view about an asset class performance is known as strategic allocation. This approach to asset allocation links individual’s risk profile and an asset allocation that is consistent with his risk profile and investment horizon and it is free from market views. If part of the portfolio is allocated as per the market views to grab short-term event-based opportunities, it is called tactical allocation. Alternatively, if one wants to automate the asset allocation using some model or screener, one can follow dynamic allocation. However, I believe that, for the purpose of financial planning, the best way is to follow strategic asset allocation process.
Risk profiling is usually done using a questionnaire to measure twin aspects of risk profile: risk capacity—a more objective and financial aspect of risk profile, and risk tolerance, a more subjective and psychological aspect of risk profile. While risk capacity is how much risk you can afford to take, risk tolerance is the risk you are willing to take. The risk profile gives a composite score of both and asset allocation is recommended using it.
Higher risk profile score is matched with an aggressive asset allocation having heavy equity tilt; on the other hand, lower risk profile score people should be recommended a conservative asset allocation with heavy debt tilt. Clients with high risk-capacity and low risk tolerance or those with low risk-capacity and high risk-tolerance get the moderate risk profile.
Moderate risk profile score people may be offered a balanced asset allocation with close to 50-50 allocation between equity and debt. Of course, one can approach the asset allocation exercise in a more sophisticated manner by looking at various criteria like return, risk, liquidity, maturity and tax-treatment of various asset classes.
The writer is faculty member in the finance department at DSIMS, Mumbai