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In last article we had discussed about Financial Planning and its need, one of the key things and deliverable while making a financial plan is to do a proper “Asset Allocation” post understanding his:

1. Financial Goals
2. Risk Taking Capacity
3. Risk Appetite

Let’s first try and understand what I mean by Asset Allocation:

What is 'Asset Allocation' – Definition as per “Investopedia”.

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon. The three main asset classes - equities, fixed-income, and cash and equivalents - have different levels of risk and return, so each will behave differently over time.

Asset allocation means investing an individual’s assets for meeting the financial plan broadly into two categories i.e. equities and debt with a portion in cash and equivalents based on the risk profiling and expected return of the individual.

Thus, for proper Asset Allocation we need to understand one’s Financial Goals and Risk-Reward Ration.

Now the question arises why Asset Allocation

It is very difficult to determine in a year which particular asset class would be the best performing one. Investing in only one class of asset could prove to be very risky. To understand - Its being time when equities have given negative returns whereas bonds yields have still beaten the inflation numbers.

As per fundamental of asset allocation there is a notion that different asset classes offer returns that are not perfectly correlated. Thus, diversification reduces the overall risk in terms of the variability of returns for a given level of expected return.  This makes it imperative to understand the goal and time horizon of investment.

Therefore, having a mixture of asset classes is more likely to meet the investor’s expectations in terms of amount of risk and possible returns.

Asset Allocation Strategy
We can broadly classify Asset Allocation Strategy into two parts:

Strategic asset allocation (SAA)
It refers to the asset allocation that aims to achieve the investor’s long-term investment objectives. It is based on the longer-term risk and return outlook for the asset classes.

Tactical asset allocation (TAA)
It aims to take advantage of perceived inefficiencies / imperfection in asset pricing in the short-term, to extend also arbitrage between two imperfect markets. The deviation from the SAA is done with the aim to enhance returns in the shorter term.

Which strategy to implement will depend on investor’s requirement and investment horizon?

One thing which is mandatory for someone going for SAA strategy is how to re-balance the portfolio in response to market fluctuations that move the asset allocation of the portfolio, as TAA is assumes for shorter term and which ends up with actual booking of portfolio.

We can broadly categorize re balancing into strategies:

Buy and Hold
A buy-and-hold strategy is a ‘do-nothing’ strategy. It is characterized by an initial mix that is bought and then held till the maturity or time horizon. No re-balancing is required; no ongoing monitoring is required and therefore, has low fund management costs.

Constant Mix
The constant-mix strategy implies a constant proportion of the portfolio to be invested in equities. Whenever the relative values of the assets change, the investor has to buy and sell to the desired mix. In general, re-balancing to a constant-mix requires the investor to buy equities as they fall in value and sell equities when they rise in value.

Constant proportion portfolio
A method of portfolio re-balance in which the investor sets a floor value of his or her portfolio, then asset allocation will be done accordingly. The two asset classes used in CPP are major portion of equity dominated asset and debt equivalents or bonds or cash. The percentage allocated to each asset class will depend on the "cushion value”, defined as (current portfolio value – floor value), and a multiplier coefficient, where a higher number denotes a more aggressive strategy.  

The investor will start investment in the equity asset equal to the value of: (Multiplier) x (cushion value) and will invest the remainder in the other asset class.  As the portfolio value changes over time, the investor will re-balance according to the same strategy. The value of multiplier is based on the investor's risk profile, and is typically derived by first asking what the maximum periodic loss could be on the risky investment. The multiplier will be the inverse of that percentage. 

Let’s take an example, One decides that 20% is the maximum "loss" possibility, the multiplier value will be (1/.20), or 5.  In a portfolio of AED 1,000,000 of which the investor decides AED 900,000 is the absolute floor value. If the portfolio falls to AED 900,000 in value, the investor would move all assets to cash or Risk Free to preserve capital. In above scenario, the investor would allocate 5 x (AED 1000,000 – 900,000) or AED 500,000 to the risky asset, with the remainder going into debt asset class. Now, if the portfolio value goes down to 900,000 he will have to re-balance the portfolio as his floor value is AED 900,000.

So as a step in making a “Financial Plan”  asset allocation plays an important role in achieving the goal set over the period of time, it is imperative to have a constant review of the allocation made and re-balancing the portfolio in order to keep them in line with the goals set and risk apatite ascertained.