Basics of asset allocation with a portfolio consisting of MFs

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 1^st 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.”