Asset Allocation

Market moves in cycles and different strategies work in different phases of cycles. Identifying cycles and positioning the portfolio accordingly can be tricky at times. One simple way to overcome this difficulty is “Asset Allocation

Asset allocation is the process of deciding what percentage of your money to put into different asset classes such as stocks, bonds and cash.

Each asset class responds differently to shifts in the economy and financial markets; some investments may be up while others may be down. With asset allocation, a portfolio may experience less fluctuation in value than individual assets within the same portfolio.

Having a disciplined approach towards investing helps in generating above average returns. Investing with discipline involves selecting investments that are in line with an overall asset allocation and diversification strategy based upon your needs, goals, time frames and your ability to assume risk. To meet their goals, investors must carefully identify their financial objectives and an investment mix to help them reach those goals.

Higher the risk, higher the reward – Is This True?

It is generally believed that, Higher the risk, higher the reward. But Asset allocation helps you in achieving similar (sometimes better) returns with lesser volatility. To give an example, since January 1995 we analysed HDFC Equity Fund and HDFC Balanced Advantage Fund (earlier HDFC Prudence Fund). Both the funds are from the same fund house and are managed by the same fund manager in a similar style. While HDFC Equity is a Multicap fund, HDFC Balanced Advantage fund is an asset allocation fund having close to 75% equity and 25% debt exposure.

As seen from the table, HDFC BAF has delivered better Risk-Adjusted Returns

Asset allocation technique may have a significant impact on the ultimate success of your portfolio. In fact, asset allocation has more influence on portfolio variance than any other single investment decision. In an important study published by the research team of Brinson, Singer, and Beebower in 1991, asset allocation was shown to account for as much as 91.5 of the variation in total return, far outweighing other significant factors such as market timing and security selection.

Developing Your Investment Strategies with Your Advisor

For deciding your Asset allocation framework, the following factors are to be considered:

  1. Time Horizon
  2. Risk Tolerance
  3. Investment vehicles
  4. Planned current and future contributions
  5. Goals

Asset allocation is not a static strategy. To be effective, an asset allocation plan should be reviewed periodically. Also, any changes in your financial goals, lifestyle, time frame and financial circumstances coupled with changes in market conditions, could necessitate revision of your asset allocation plan.

Financial planning: A case study

The Eisenhower matrix for decision making directs to schedule time, to do task that is IMPORTANT but not urgent. But, the urgency is not there even at the scheduled time and hence the fate of this quadrant is often procrastination. The primary reason for procrastination in financial planning is starting problem. Perhaps a DIY kit could help with that. But is there a DIY kit/instruction booklet for financial planning? The chances are pretty high! However, more important questions are- do I have time & resources to do it myself? And will an Excel spreadsheet or an online calculator personally understand me and my needs? Such programs are yet to reach that level. Here I endeavor to lay a sample case construct that will help you get started.

Client Profile

A tech entrepreneur in early 40’s with nearly 18 years’ experience, married to a finance professional turned entrepreneur nearing 40’s. They had two daughters.

Current Financial Position
Major Financial Goals
  1. Maintain current lifestyle after retirement at age 55: Cost of living increases every year due to inflation. So the client will want Rs. 7.8L per year adjusted for inflation post retirement. 
  2. To provide for education and wedding expenses of daughters. Education is a necessity and must be prioritized. Education expenses were modeled over today’s fees for school of client’s choice and higher education cost overseas. Wedding on the other hand, will be towards end of client’s earning period and is a discretionary expense. It may be difficult to put a number on such goal. After some consultation client decided to aim for Rs. 15 L of today’s value for each daughter’s wedding.
Unstated Financial Goals

At the time of our discussion there were no other goals such as new car or holiday abroad as these were either not required or were being comfortably managed from discretionary expense mentioned in table above. But many people do have such aspirational goals.  

Major Concerns

While looking through a telescope, a millimeter movement in the tube towards your eye results in focus shifting by a few kilometers in your frame. Similarly, even though one is earning comfortably today, like our client, everyone is concerned about shortfall risk- that is whether the goals will be sufficiently funded at the time they become due.

This is because both inflation and returns compound over longer term and result in telescope-like effect. If the investment portfolio doesn’t generate returns in excess of inflation (real returns) over longer term then the value of goal will be higher than the provision.

Behavioral Analysis

The ultimate objective of financial planning is to comfortably meet financial goals and have mental peace in the journey. Generating returns is means to achieve these goals and not an objective. Behavioral analysis aids to address the later part of the objective.

Behavioral analysis reveals following biases-

Familiarity – Investments in real estate were mainly due to the comfort in asset class.

Status Quo– Reluctance to divest from real estate despite being convinced that there are better options.

Lack of self-control– Expenses funded by credit card and personal loan despite high income level. A part of it was unawareness of 36% annual interest on credit card loans.

However, client was open to let go of investment control and assume oversight responsibility. He was rational and responsive to revelations of risk-return dynamics of various asset classes.  The factors discussed here, along with many other forms a client’s case and aid in decisions regarding asset allocation and selection of investment instruments.

This, along with risk profiling helps to decide whether client can tolerate risk. The purpose here is to get you started with understanding yourself and collect data. I am deliberately not putting any analysis and solution because, in my experience this leads to reverse-engineering: people try to frame the case keeping in mind the solution they desire. The objective is to find a key that opens the lock not the other way round!