Asset allocation is the process of deciding how to distribute your wealth among different asset classes for investment purpose. An asset class comprises securities that have similar characteristics, attributes, and risk return relationships. The asset allocation decision is not an isolated choice rather, it is a component of a portfolio management process. Let us discuss the portfolio management process.
The first step in the portfolio management process is to construct a policy statement. It is like a road map wherein investors should assess the types of risks they are willing to take and their investment goals and constraints. All investment decisions are based on the policy statement to ensure they are appropriate for the investor. As investor needs change over time, the policy statement must be periodically reviewed and updated. A policy statement does not guarantee investment success but will provide discipline for the investment process and reduce the possibility of making hasty, inappropriate decisions. But it helps the investor to decide on realistic investment goals after learning about the financial markets and the risks of investing.
In the second step of the portfolio management process, the investor should assess current financial and economic conditions and forecast future trends. Investor needs, as reflected in the policy statement, and financial market expectations will jointly determine investment strategy. Economies are dynamic and they are affected by numerous industry struggles, politics, and changing demographics and social attitudes. Thus, the portfolio
will require constant monitoring and updating to reflect changes in financial market expectations.
Implement the plan
The third step of the portfolio management process is construction of the portfolio. With the investor’s policy statement and financial market forecasts as inputs, one should implement the investment strategy and determine how to allocate available funds across different markets, asset classes, and securities. This involves constructing a portfolio that will minimise the investor’s risks while meeting the needs specified in the policy statement.
The fourth step in the portfolio management process is the continual monitoring of the investor’s needs and capital market conditions and, when necessary, updating the policy statement. Based upon all of this, the investment strategy is modified accordingly. A component of the monitoring process is to evaluate a portfolio’s performance and compare the relative results to the expectations and the requirements listed in the policy statement.
A carefully constructed policy statement determines the types of assets that should be included in a portfolio. The asset allocation decision, not the selection of specific stocks and bonds, determines most of the portfolio’s returns over time. Although seemingly risky, investors seeking capital appreciation, income, or even capital preservation over long time periods will do well to include a sizable allocation to the equity portion in their portfolio.
As noted, a strategy’s risk may depend on the investor’s goals and time horizon. At times, investing in treasury bills may be a riskier strategy than investing in common stocks due to reinvestment risks and the risk of not meeting long-term investment return goals after considering inflation and taxes. To conclude, although there are no shortcuts or guarantees to investment success, maintaining a reasonable and disciplined approach to investing will increase the likelihood of investment success over time.
The writer is professor of finance & accounting, IIM Shillong