Asset allocation, as explained above, is a process wherein an investor takes a decision of how his portfolio will be diversified. Diversification is an important goal for an investor. Putting all the savings in equity market might not be a safe investment decision while investing in fixed income securities is also not advisable looking at the return potential of such securities. The lower the risk profile of an investor, the more should be her investment in safer securities.
Which sector is going to be the hottest? Are large-caps less volatile than small-cap? Bonds may not be the right investment going forward due to increase in interest rates in coming times? Dollar is trading at one-month high?
We all come across such statements almost every day. For an investor it is important to know how his portfolio might get affected by such and similar statements. Experts say that markets reward investors with returns earned by three ways – Asset Allocation, Market timing and security selection.
Empirical analysis says that over 91% of long-term portfolio performance is derived from the decisions made regarding asset allocation, and not market timing or security selection. But what is asset allocation? An asset class can be said to be a group of securities which have common characteristics – risk, maturity, cost of trading, etc. When an investor based on his risk profile and return expectations distributes his funds into various asset classes, she is said to be doing asset allocation. For a common investor, stocks and fixed income securities are two main asset classes. Other classes could be currency, commodities, real estate, etc. We will get into more detail of asset allocation later. An investor is said to be getting involved in market timing when she makes a buy or sell decision based on her prediction of the market movement. Say for example, Renu buys telecom stocks thinking that this sector has seen a major hit recently, the sector did not deserve such a fall and the market shall correct in recent future. Security selection is the most exciting one of the three. It is the process of finding the securities for investment. There are various methods developed to do security selection especially in equity market. Most common being top-down and down-up approach. One can find millions of website explaining what these processes are. So let us move forward and explore asset allocation.
Asset allocation, as explained above, is a process wherein an investor takes a decision of how his portfolio will be diversified. Diversification is an important goal for an investor. Putting all the savings in equity market might not be a safe investment decision while investing in fixed income securities is also not advisable looking at the return potential of such securities. The lower the risk profile of an investor, the more should be her investment in safer securities. There is a trade off between this game of risk and return as the less risky is the portfolio, the less probability of getting higher return.
Let us get this clear with an illustration. An investor, Ramesh, does an analysis of the equity market and predicts a 15% return over the next year. For bonds and debt mutual funds, he forecasts a 8% return. Now based on his allocation, the portfolio return could vary as shown in table below –
| Scenarios | Equity (Return =15%) | Fixed Income(Return =8%) | Portfolio Return |
| 1. | 25% | 75% | 9.75% |
| 2. | 50% | 50% | 11.50% |
| 3. | 75% | 25% | 13.25% |
So, as one can see, asset allocation can result in huge difference in our returns. In the above illustration, Ramesh can have highest return of 13.25% and minimum return of 9.75%, a difference of 3.5%. But these are broad asset classes’ returns. Actual returns, dependent also on market timing and security selection, may be more or less.
The above exercise of asset allocation must not give the impression that it is as simple as it looks. The next step is to zero down on the second-tier securities. For example, Ramesh decides that based on his risk profile he will allocate more funds in equity. The next step is, in what bracket of equity market will he dedicate his funds. The broad classification of equity market can be large cap, mid cap, small cap and foreign stocks. Another classification can be based on style of investing in equity – value or growth. In debt securities, money market mutual funds, debt funds, corporate debt securities, etc. are some of the sub-classes to invest.
Asset allocation is a continuous process wherein an investor is required to undertake decisions on revision of allocation based on past performance of her portfolio, changes in market variables, economic indicators and risk profile.
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