Asset Allocation: Guidelines for asset Allocation

Asset allocation is the implementation of an investment strategy that attempts to balance risk
versus reward by adjusting the percentage of each asset in an investment portfolio according to
the investor’s risk tolerance, goals and investment time frame. The focus is on the characteristics
of the overall portfolio. Such a strategy contrasts with an approach that focuses on individual
assets.

Many financial experts argue that asset allocation is an important factor in determining returns
for an investment portfolio. Asset allocation is based on the principle that different assets
perform differently in different market and economic conditions.

A fundamental justification for asset allocation is the notion that different asset classes offer
returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of
the variability of returns for a given level of expected return. Asset diversification has been
described as “the only free lunch you will find in the investment game”. Academic research has
painstakingly explained the importance and benefits of asset allocation and the problems of
active management (see academic studies section below).

Although the risk is reduced as long as correlations are not perfect, it is typically forecast
(wholly or in part) based on statistical relationships (like correlation and variance) that existed
over some past period. Expectations for return are often derived in the same way. Studies of
these forecasting methods constitute an important direction of academic research.

When such backward-looking approaches are used to forecast future returns or risks using the
traditional mean-variance optimization approach to the asset allocation of modern portfolio
theory (MPT), the strategy is, in fact, predicting future risks and returns based on history. As
there is no guarantee that past relationships will continue in the future, this is one of the “weak
links” in traditional asset allocation strategies as derived from MPT. Other, more subtle
weaknesses include seemingly minor errors in forecasting leading to recommended allocations
that are grossly skewed from investment mandates and/or impractical often even violating an
investment manager’s “common sense” understanding of a tenable portfolio-allocation strategy.

Allocation strategy

There are several types of asset allocation strategies based on investment goals, risk tolerance,
time frames and diversification. The most common forms of asset allocation are: strategic,
dynamic, tactical, and core-satellite.

1. Strategic asset allocation

The primary goal of strategic asset allocation is to create an asset mix that seeks to provide the
optimal balance between expected risk and return for a long-term investment horizon. Generally
speaking, strategic asset allocation strategies are agnostic to economic environments, i.e., they do
not change their allocation postures relative to changing market or economic conditions.
 2. Dynamic asset allocation

Dynamic asset allocation is similar to strategic asset allocation in that portfolios are built by
allocating to an asset mix that seeks to provide the optimal balance between expected risk and
return for a long-term investment horizon. Like strategic allocation strategies, dynamic strategies
largely retain exposure to their original asset classes; however, unlike strategic strategies,
dynamic asset allocation portfolios will adjust their postures over time relative to changes in the
economic environment.

3. Tactical asset allocation

Tactical asset allocation is a strategy in which an investor takes a more active approach that tries
to position a portfolio into those assets, sectors, or individual stocks that show the most potential
for perceived gains. While an original asset mix is formulated much like strategic and dynamic
portfolio, tactical strategies are often traded more actively and are free to move entirely in and
out of their core asset classes.

4. Core-satellite asset allocation

Core-satellite allocation strategies generally contain a ‘core’ strategic element making up the
most significant portion of the portfolio, while applying a dynamic or tactical ‘satellite’ strategy
that makes up a smaller part of the portfolio. In this way, core-satellite allocation strategies are a
hybrid of the strategic and dynamic/tactical allocation strategies mentioned above.

Classification of Assets

Mostly assets are classified based on 3 broad categories:

1. Traditional assets

The “traditional” asset classes are stocks, bonds, and cash:

 Stocks: value, dividend, growth, or sector-specific (or a “blend” of any two or more of
the preceding); large-cap versus mid-cap, small-cap or micro-cap; domestic, foreign
(developed), emerging or frontier markets
 Bonds (fixed income securities more generally): investment-grade or junk (high-yield);
government or corporate; short-term, intermediate, long-term; domestic, foreign,
emerging markets
 Cash and cash equivalents (e.g., deposit account, money market fund)

1. On the basis of Convertibility fixed assets or current assets.

2. On the basis of Physical existence tangible and intangible.
3. On the basis of Purpose operating and non-operating assets.
Current assets or short-term assets

These types of assets can be readily converted into cash or its equivalent resources typically
within a year and are known as liquid assets. For example, cash equivalents, stock, marketable
securities and short-term deposits are some of the most common current assets.

Fixed assets or long-term assets

Also known as hard assets and fixed assets, these resources are not easy to convert into cash or
its equivalent kind. Generally, land, machinery, equipment, building, patents, trademarks, etc. are
considered as fixed assets.

Tangible assets

Similarly, assets with a physical existence are categorised as tangible assets. Resources like
stock, land, building, office supplies, equipment, machinery and marketable securities, among
others are functioning examples of tangible assets.

Intangible assets

On the contrary, assets which do not possess a physical existence come under the category of
intangible assets. The best examples of such assets would be market goodwill, corporate
intellectual property, patents, copyrights, permits, trade secrets, brand, etc.

Operating assets

Assets like cash, building, machinery, equipment, copyright, goodwill, stock, etc. are termed as
operating assets. Typically, such assets are used to generate revenue and to maintain daily
operation.

Non-operating assets

Though these assets are not used for performing daily operations, they tend to help generate
significant revenue. Some of the best examples of non-operating assets are short-term
investments, vacant land, income generated through fixed deposits, etc.

Alternative assets

Other alternative assets that may be considered include:

 Commodities: precious metals, nonferrous metals, agriculture, energy, others.

 Commercial or residential real estate (also REITs)
 Collectibles such as art, coins, or stamps
 Insurance products (annuity, life settlements, catastrophe bonds, personal life insurance
products, etc.)
 Derivatives such as options, collateralized debt, and futures
  Foreign currency
 Venture capital
 Private equity
 Distressed securities
 Infrastructure
 Hedge funds

Risk returns characteristics of assets

In asset allocation planning, the decision on the amount of stocks versus bonds in one’s portfolio
is a very important decision. Simply buying stocks without regard of a possible bear market can
result in panic selling later. One’s true risk tolerance can be hard to gauge until having
experienced a real bear market with money invested in the market. Finding the proper balance is
key.

Risk and return are highly correlated. Increased potential returns on investment usually go hand-
in-hand with increased risk. Different types of risks include project-specific risk, industry-
specific risk, competitive risk, international risk, and market risk. Return refers to either gains
and losses made from trading a security.

The return on an investment is expressed as a percentage and considered a random variable that
takes any value within a given range. Several factors influence the type of returns that investor
can expect from trading in the markets.

The risk associated with investments can be thought of as lying along a spectrum. On the low-
risk end, there are short-term government bonds with low yields. The middle of the spectrum
may contain investments such as rental property or high-yield debt. On the high-risk end of the
spectrum are equity investments, futures and commodity contracts, including options.

Investments with different levels of risk are often placed together in a portfolio to maximize
returns while minimizing the possibility of volatility and loss. Modern portfolio theory (MPT)
uses statistical techniques to determine an efficient frontier that results in the lowest risk for a
given rate of return. Using the concepts of this theory, assets are combined in a portfolio based
on statistical measurements such as standard deviation and correlation.

Diversification allows investors to reduce the overall risk associated with their portfolio but may
limit potential returns. Making investments in only one market sector may, if that sector
significantly outperforms the overall market, generate superior returns, but should the sector
decline then you may experience lower returns than could have been achieved with a broadly
diversified portfolio.

The correlation between the hazards one runs in investing and the performance of investments is
known as the risk-return tradeoff. The risk-return tradeoff states the higher the risk, the higher
the reward and vice versa. Using this principle, low levels of uncertainty (risk) are associated
with low potential returns and high levels of uncertainty with high potential returns. According
to the risk-return tradeoff, invested money can render higher profits only if the investor will
accept a higher possibility of losses.

Investors consider the risk-return tradeoff as one of the essential components of decision-
making. They also use it to assess their portfolios as a whole.

Risk Tolerance

An investor needs to understand his individual risk tolerance when constructing a portfolio of
assets. Risk tolerance varies among investors. Factors that impact risk tolerance may include:

 Future earnings potential.

 The size of the portfolio.
 Ability to replace lost funds.
 The presence of other types of assets: equity in a home, a pension plan, an insurance
policy.
 The amount of time remaining until retirement.

Problems with asset allocation

 Investors agree to asset allocation, but after some good returns, they decide that they
really wanted more risk.
 Investor behavior is inherently biased. Even though investor chooses an asset allocation,
implementation is a challenge.
 Investors agree to asset allocation, but after some bad returns, they decide that they really
wanted less risk.
 Security selection within asset classes will not necessarily produce a risk profile equal to
the asset class.
 Investors’ risk tolerance is not knowable ahead of time.
 The long-run behavior of asset classes does not guarantee their shorter-term behavior.

Risk and Return Models

 APM
 Proxy models
 Multifactor model
 Accounting and debt-based models
 The Capital Asset Pricing Model (CAPM)

Managing Risk and Return

Formulas, strategies, and algorithms abound that are dedicated to analyzing and attempting to
quantify the relationship between risk and return.

Roy’s safety-first criterion, also known as the SFRatio, is an approach to investment decisions
that sets a minimum required return for a given level of risk. Its formula provides a probability of
getting a minimum-required return on a portfolio; an investor’s optimal decision is to choose the
portfolio with the highest SFRatio.

Another popular measure is the Sharpe ratio. This calculation compares an asset’s, fund’s, or
portfolio’s return to the performance of a risk-free investment, most commonly the three-month
U.S. Treasury bill. The greater the Sharpe ratio, the better the risk-adjusted performance.