Most people think that its all about stock picking, and timing that leads to money making. While it may be true for someone whose only job is to manage investment, it is certainly not the case for an individual who already has a full-time job!
The trick to getting higher returns on your savings is understanding the art and science of asset allocation and practicing it, while making sure that you don't give it too much time or too less a time.
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It is not often that I would update an old post. But here in making an exception is perhaps necessary. Just in case if you are more interested in reading the original draft and a cruder version then it's given below.
The
key to wealth is Asset Allocation
The right asset
allocation model is the key to building a mutual fund portfolio that helps you
achieve your goals. First let’s refresh you on the basics of asset allocation. There
are broadly 5 asset classes – equities, debt, foreign funds, realty, others and
index funds. And within each asset classes there are many other sub-assets.
(Refer: Asset Class Chart)
“The importance
of asset Allocation to investment is similar to what oxygen is to human life,”
says Rohit Shah, Founder of GettingYouRich. In Determinants of Portfolio Performance II: An Update by Gary P. Brinson, Brian D. Singer and Gilbert
L. Beebower published in Financial
Analysts Journal, May-June 1991, “It has been observed that 91% of the
portfolio performance is linked to asset allocation. One typically has 40 to 50
years of life left after one starts earning money. Over such a long period of
time, we believe that one's ability to move in and out of the right asset will
be a key determinant to the portfolio ROI.”
Ajit Menon, EVP
DSP Black Rock also reiterates the view, says “asset allocation is the best
method of determining the right outcome for your investments. Close to 93.6% of
the outcome of a portfolio is determined by the asset allocation you had and not
by the stocks or products that you chose.”
PART -1
Now that we
have established the importance of asset allocation, the next question for
anyone would be, what is this wand of Asset allocation? Simply put, it is
building the right portfolio to suit your needs.
Building a
portfolio is a combination of art and science. It’s an art because one has to
understand the investor’s risk appetite. “To build a portfolio using mutual
funds, investor should link the investments to goals and map the schemes to
risk profile”, says Shah of GettingYouRich.
The second
question i.e. the science of building a portfolio is how do you actually do it?
Before setting in the process to build a portfolio, one must give strong
foundations by way of risk profiling and writing down their investment policy.
Menon of DSP
Black Rock explains this in detail, “risk profile is made up of two parts -
risk tolerance and risk capacity.” He further explains that risk capacity may vary,
as it is based on circumstances, while risk tolerance is a natural bent and
this doesn't change dramatically over a period of time. It will change
marginally in 5-7 years.
A lot of people
don’t believe in risk profiling, their argument is that risk profile changes
from time-to-time. This is supplemented with the anecdote that, ‘when the
market is not doing well, everyone’s risk profile is low. When it is doing
well, suddenly everyone’s risk profile is high’. To exemplify, Menon says that
an adventurous person would like to go for trekking, scuba diving and snowboarding.
But when it is raining that person will not go out for trekking, but that
doesn't mean the person is not an adventurer. Therefore risk tolerance is an
inherent attitude towards risk.
Whereas risk
capacity is different. If you have a dependent child, etc. then your risk
capacity will perhaps be at the low; whereas if a person is single in a senior
position with no dependant’s and no responsibilities then risk appetite could
be very high.
Typically, as
retail investors we all want the maximum returns at the lowest possible risk.
However, we ought to be rational and realistic about risk and need to be
risk-aware instead of being risk-averse. “If we are seeking good long term
returns, our risk appetite needs to be congruent to the desired returns”, says Puneet
Chaddha, CEO HSBC Global Asset Management, says.
Hence it is
advisable and it’s best that for risk assessment, one meets a financial
advisor.
After
understanding one’s risk profile, investors should write an investment policy
with goals and timelines clearly stated in it along with the risk
assessment. This should also be
periodically reviewed.
Chaddha opines
its best an investment policy is drawn between investor and financial advisor,
where they agree to issues relating on how the investor's money will be managed
and a drawdown of the financial goals and risk profile of the investor. “It is
always a good practice to have it documented as both the investor as well as
the financial advisor is absolutely clear on the expectations and deliverables”,
adds Chaddha. Sanjay Chawla, Chief Investment Officer, Baroda Pioneer AMC adds,
“Since goals and risk profile of individuals will change over time, it is
important that the policy be revisited and updated at least once a year.”
Investment Policy (SAMPLE)
Goals
|
Time frame (years)
|
Portfolio composition
|
SIP/Lump-sum
|
Sons Education
|
14
|
Equity 60%, Long term Debt 25 % ,
Short term debt or
cash equivalents 15% or 5%
|
10,000 SIP
|
My retirement
|
30
|
Equity 75%, Debt 20% , Short
term 5%
|
5,000 SIP
|
My European
holiday
|
2
|
Equity -0%, Fixed Debt 80%, Liquid 20%
|
10,000 SIP
|
PART
- 2
The key theme
that is achieved with asset allocation is portfolio diversification. Different asset classes and sub-set of asset classes do well in different
periods of time, making it imperative that one invests across asset-classes
depending upon their goal, time horizon and risk appetite.
Performance of
different asset classes
Within asset
classes, different sub sets also behave differently. Take for instance year 2013.
The Large-cap fund category returned ~6% whereas mid- and small-cap funds
returned ~3%. In the debt category income funds returned ~5% and liquid fund
index returns were around 8.76%. On the other hand sector funds like technology
fund returns were around 52%! Imagine if you were fully invested in midcaps in
2013 or if you were fully invested in liquid funds in 2005 when the liquid fund
index returns were ~5%. (See: Best Performing Mutual Fund Category)
So there was a
wide spread in returns from different asset classes/geographies. This is what
active asset allocation seeks to address. Active asset allocation would adjust
the portfolio exposure into various asset classes depending on their relative
attractiveness, hence giving you the best possible outcome.
Chaddha says, asset
allocation does not ensure a profit or guarantee against a loss – it can
however, lead to better risk adjusted portfolio returns over time. “Hence, an
active asset allocation portfolio adjusted for the investors’ respective risk
profile could provide a good solution for the investors’ needs”, he adds.
Asset
allocation is also the key to protect wealth. This is supported by a study, Karan
Datta, National Sales Head at Axis Mutual Funds. “If we take the three base
assets that is available to investors quite easily by way of mutual funds --
equities, bonds and gold, then in any single year two assets outperforms and
the one asset class underperforms. Timing this is very difficult as we all
know. Our study shows that if an equally weighted portfolio was managed then in
the last 15 years that portfolio would have given negative returns only in one
year and that wouldn’t have been 2008 but mid-1990s.” (See: Category Performance)
Part – 3
There are
various asset allocation models you can consider once you have established your
investment policy. Although
customized asset allocation will be created by a financial advisor based on a
person’s needs and risk profile. There
are three most common and talked about asset allocation model – Strategic Asset
Allocation, Dynamic Asset Allocation, and Risk & Time Matrix Asset
Allocation.
Strategic
asset allocation: The individual composition of each asset allocation for each
goal depends on your horizon and risk appetite and you must stick to this till
your goal is achieved. Herein, the idea is to maintain the balance by selling
over weighted assets and buying underweighting asset. The
advantage is you need less monitoring and management fees; it reduced your risk
too.
The idea here
is that once an asset allocation like 60 equity and 40 debt is set then it
should only be rebalanced once a year. Best suited for most investors.
Example, Ram is
an investor who is saving Rs 10,000 a month for his retirement, which is 25
years away, and he started savings from 1st Jan 2004. His investment
policy states his risk taking capacity is moderate, that for the next 15 years
he will be maintaining an asset allocation of 70% in equity and 20% in income
fund and 10% in gold. And he will rebalance his portfolio on every Jan 1 of the
subsequent years. (See chart on
performance of Ram’s balanced portfolio vis-à-vis each individual asset class:
Asset Allocation Sample).
Dynamic
asset allocation: Your allocation is based on market factors, you decide the
weightage based on the current market situation and the future outlook. You
need to actively manage the fund, it will be more expensive and volatile, and
not to mention the success depends on getting many factors right most of the
time. Biju Behanan of Finwell India says, we do not recommend this strategy to
investors as it is time consuming and highly volatile. While under strategic
asset allocation you will have to rebalance once a year, under this philosophy
it should be quarterly monitoring and one will have to take a call on the direction
of the market.
Example, Shyam
is also an investor, but he follows dynamic asset allocation. For this reason
he reviews his portfolio every month and adjusts his asset allocation based on
the economic and asset outlook that he perceives.
Risk
& Time Matrix Asset Allocation: One can look at Aggressive, Balanced or
Conservative asset allocation based on profile, goal requirements and available
surplus.
(Given below is
a sample of asset allocation matrix. It can vary depending upon the investment
advisor)
Risk
Profile/
Time Horizon |
Upto
2 years |
2
-5 year |
More
than 5 years |
Conservative
(Low Risk) |
Liquid Fund 50%,
Income Fund 50%
|
Income
Fund 70%,
Balanced Fund 30% |
Diversified
Equity 70%,
Income 20%,
Gold 10% |
Balanced
(Medium Risk) |
Liquid Fund 20%,
Income Fund 80% |
Income
Fund 50%,
Balanced Fund 50% |
Diversified Equity
40%,
Midcap Funds 30%,
Income Fund 20%,
Gold 10% |
Aggressive
(High Risk)
|
Liquid Fund 20%,
Income Fund 70%,
Balanced Fund 10% |
Diversified Equity
30%,
Midcap Funds 20%,
Income Fund 40%,
Gold 10% |
Diversified Equity
30%,
Midcap Funds 30%,
Thematic Funds 10%,
Income Fund 20%,
Gold 10% |
Rohit Shah of
GettingYouRich, emphasizes that with passing of time, one is likely to have
discharged responsibilities and with increasing age one typically needs to move
towards less volatile investments. He further adds, “If the critical goals are
discharged, then one can choose to be more flexible on asset allocation. On the
other hand, if the goals are coming to maturity, then one may have to start
moving the accumulations from say Equity MF to Debt MF.”
