PORTFOLIO MANAGEMENT FRAMEWORK:

ASSET ALLOCATION

Asset allocation is one of the most important steps in portfolio management process. The initial step for the financial planner is to determine the required rate of return based on financial goals, risk tolerance and time horizon.

The second step is to ascertain capital market expectations, as well as the expected return and expected volatility of each asset classes.

DEFINITION Asset allocation is an investment

strategy by which an investor or a portfolio manager attempts to balance risk versus reward by adjusting the percentage of amount invested in an asset of a portfolio according to the risk tolerance of the investor, his/her goals and the investment time frame. 

Categories: Cash, Bonds, Stocks, Real Estate, Precious Metals and Others.

In its simplest terms, asset allocation is the practice of dividing resources among different categories such as stocks , bonds, mutual funds, investment partnerships, real estate, cash equivalents and private equity.

The goal of asset allocation is to reduce risk through diversification by having exposure to a variety of investments that perform differently during various market conditions.

BENEFITS OF ASSET ALLOCATION Reduced risk: A properly allocated

portfolio strives to lower volatility, or fluctuation in return, by simultaneously spreading market risk across several asset class categories.

More consistent returns: By investing in a variety of asset classes, you can improve your chances of participating in market gains and lessen the impact of poorly performing asset class categories on overall results.

A greater focus on long-term goals: A properly allocated portfolio is designed to alleviate the need to constantly adjust investment positions to chase market trends. It can also help reduce the urge to buy or sell in response to short-term market swings.

ASSET ALLOCATION STRATEGIES

Strategic Asset Allocation Tactical Asset Allocation Constant-Weighting Asset Allocation Balanced Asset Allocation Dynamic Asset Allocation

Strategic Asset Allocation:assigning weights to different asset classes

on the basis of an investor’s risk and return objectives and the capital market expectations.

Tactical Asset Allocation: tactical asset allocation allows investors to

make short-term deviations from asset weights assigned in strategic asset allocation strategy.

Constant-Weighed Asset Allocation: With this approach, you continually rebalance your

portfolio. For example, if one asset is declining in value, you would purchase more of that asset; and if that asset value is increasing, you would sell it.

Balanced Asset Allocation: provides a framework to rebalance the portfolio to

the ratio of the original asset mix. It involves selling the securities in the asset class which has appreciated in value and investing in other asset classes to restore the original asset mix.

Dynamic Asset Allocation: constantly adjust the mix of assets as markets rise

and fall, and as the economy strengthens and weakens.

CONVENTIONAL WISDOM ON ASSET ALLOCATION

There are two propositions:1. Risk Tolerance An investor with greater tolerance of risk

should tilt the portfolio in favour of stocks, whereas an investor with lesser tolerance for risk should tilt the portfolio in favour of bonds.

2. Time HorizonAn investor with a longer investment

horizon should tilt the portfolio in favour of stocks whereas an investor with a shorter investment horizon should tilt the portfolio in favour of bonds. This is because the risk from stocks diminishes as the investment period lengthens.

RISK-RETURN RELATIONSHIP FOR VARIOUS TYPES OF BONDS AND STOCKS

MODEL PORTFOLIOS

APPROPRIATE PERCENTAGE ALLOCATION OF THE STOCK

Risk ToleranceTime Horizon Low Moderate High

Short 0 25 50Medium 25 50 75

Long 50 75 100

CONCLUSION

“Don't put all your eggs in one basket.”