Asset Allocation

When it comes to investing for future, there's only one sure bet- Asset Allocation. Trying to outperform the market is a gamble. If you're serious about investing for long run, you have to take a commonsense approach to your portfolio.

Diversification is standard practice in portfolio management process. 
Spreading your investments in several different asset classes helps you reduce the risk of a large loss and increase performance in the long-term.

Different asset classes here refers to Cash, Equities, Bonds, Commodities , Real estate and other alternative investment vehicles like Hedge funds, Venture Capital funds. 

Asset Allocation is an investment strategy that attempts to balance between risk and reward by adjusting 

the percentage of each asset in an investment portfolio according to investors risk tolerance, goals and investment time horizon.

Asset Allocation process examines two basic steps,

First step includes the screening process to decide whether an asset class fits a portfolio.

Second step includes using correlation analysis during the selection process.

A well-diversified portfolio holds investment from multiple asset classes. The benefit from this strategy is portfolio risk is lowered and performance is enhanced over time.

Asset class selection plays an important role during the Asset Allocation process. We need to consider three main and important points when selecting asset classes.

1. Fundamentally different:

An asset classes must be fundamentally different from each other and have unique risk. Stocks and bonds are fundamentally different, one is ownership and the other is loan. Real estate and commodities differ from common stocks in structure. Correlation analysis is used to see how each asset class behaves during different phases of business cycle.

2. Real return :

An asset class must generate a real return in the long-term (Inflation Adjusted). Each asset class behaves differently during different phases of business cycle and generates different returns. Portfolio return needs to be considered when analyzing the complete portfolio performance. Portfolio return is the weighted average return of each asset in the portfolio.

Stocks have outperformed inflation by about six percent historically and real estate has earned about the same. Government bonds have outperformed by about two percent.  In contrast, commodities have no expected return over the inflation rate and do not pass this gate.

3. Liquidity:

An asset class must have high liquidity. Stocks that trade on an organized exchange and bonds that trade over-the-counter are considered as highly liquid instruments.

Real estate ownership lacks liquidity, although real estate investment trusts (REITs) are exchange traded and considered liquid. Coins, artwork and other collectables tend to be illiquid.

Asset Allocation Strategies

Strategic Asset Allocation

Strategic Asset Allocation starts from setting target allocations called “Base Policy Mix” based on expected return of each Asset class and then periodically re-balancing the portfolio back to those targets as investment returns skew the original asset allocation percentages. 

Tactical Asset Allocation

In a long run, sometimes we may find it necessary to occasionally engage in short-term, tactical deviations from the mix in order to capitalize on unusual or exceptional investment opportunities. This flexibility adds a component of  market timing to the portfolio, allowing us to participate in economic condition that are more favorable for one asset class than for others.

Points to consider before doing Asset Allocation:

1.       Risk Profile

2.       Expected Return on Investment

3.       Tax Implications

4.       Time Horizon

5.       Any other unique conditions.

Additional points to consider are Age, Work profile, current net worth, Cash flow, and Goals.

Conclusion

Be aware that allocation approaches that involve anticipating and reacting to market movements require a great deal of expertise and talent in using particular tools for timing these movements.

    

Stagflation

Every day in the News we hear Professionals & Economists talk about GDP, Inflation, Unemployment, Ratings, Monetary policy, Fiscal policy etc.

Q: As an Investor, should you know these concepts? If yes, How do these effect your investment's performance?

Macro economics is a broad subject. Here we will try to understand one of the concept called “Stagflation”

Stagflation refers to a situation of weak economic growth embedded with high unemployment and increasing Inflation. The main reason for stagflation is sharp decrease in aggregate supply. Which means decrease in the total supply of goods and services that the firms/companies are willing to sell at a given price level in that economy. This results in sudden unexpected increase in prices for those goods and services, which is often referred to as “Supply Shock”. As a result of this GDP of the economy decreases.

 

US Stagflation 1970-1979

What are the Solutions to this problem?

Government intervention either by Fiscal Expansion (Increasing government spending or decreasing taxes which may also results in Budget Deficit) and Monetary Expansion (Increasing the money supply or decreasing the Nominal Interest Rate). 

The objective is to increase the economic stimulus , Increase output ,Expand demand and create more jobs .

However, these are all short run strategies.

Stagflation is a challenging situation for Policymakers. 

Policy changes to reduce Inflation tend to make unemployment worse and policy changes to fight recession tend to make inflation worse.

If the Government does not intervene, decline is Wages and Input Prices used in Production Process will help bring back the situation to Equilibrium where aggregate demand is equal to aggregate supply. 

This is slow process and is politically risky, if the government fails to take immediate action.

How does this effect Investors?

• This situation will discourage investment in Fixed Income instruments because of anticipation of Higher Inflation and Nominal Interest Rate.
• The situation will also discourage investment in Equities as Revenue and profit margins are thin.

Ans: Suggestion for Investors:

A good strategy is to stay invested, however well diversified.

Some of the asset classes which will outperform during Stagnation are,

1. Real Assets. ( Real Estate)
2. Commodities. ( Gold, Precious Metals, Timber ,Copper etc.)
3. International Investments.(Economy which is not under the influence of Stagflation)

Investors could also consider Low P/E Stocks and Long Term Bonds as a long term investment strategy.

However, be sure that you have done enough research before you consider any of the above during stagflation.

Investing involves risk of loss or under performance. As an intelligent investor you could consult your Financial Planner/Investment Advisor before considering the above.

Importance of Alternative Investments in Portfolio Diversification

Alternative investments, which have been used by large institutions for quite some time, have become more mainstream in recent years. Individual investors are more attracted towards Alternative investments in the recent past.

An alternative investment collectively refers to many asset classes that fall outside the traditional asset classes like Stock, bond and cash. Category includes Hedge Funds, Private equity (Venture Capital and Leveraged Buyout), Real Estate, Commodities (Managed Futures), structured products and Collectibles.  Given their non-traditional approach and their ability to invest in areas and ways traditional investments cannot, and their low correlation to traditional investments they have the potential to improve the overall risk-return characteristics of a portfolio and enhance the portfolio diversification.

Some of the Strategies and approaches in Alternative Investment includes, Holding both Long and Short position in the security, Holding private securities instead of publicly traded securities, Using Derivative products and Leverages, Exploiting Pricing Discrepancies between different asset classes, Real Estate investments includes Residential and Commercial property and REIT’s( Real Estate Investment Trusts ) and Investments in Commodities. Some Wealthy Investors even consider investing is collectibles like Stamps, Wine, Antiques, and valuable Arts.

Benefits of Alternative Investments:

There is evidence that over the last 20 years, returns on Alternative Investments have been higher than the return on traditional asset classes. Despite unique and higher risks considerations, alternative investments can be useful tools to improve the risk-return characteristics of an investment portfolio. They can increase diversification and reduce volatility, given low correlations to more traditional investments. They can offer the potential for enhanced returns due to the wider investment opportunity set. And they can hedge certain portfolio exposures, thereby reducing concentration risk.

Disadvantages of Alternative Investments:

Some of the Disadvantages and Risks associated with investment in Alternative investments are, Higher Fees structures, more complicated strategies which the layman cannot understand, less transparency and Liquidity, Credit risk, disappointing  returns during strong up markets and most importantly no diversification during down market trends.    

To Conclude, with increased investment knowledge of modern investors and readily available information on Alternative Investments, these products looks more attractive to the common investors. Considerations one has to keep in mind before incorporating alternative investments are their approach towards it and appropriate asset allocation. Some of the due diligence one has to consider before investing is, Product’s Investment Strategy and Process, Historical return and Valuation, AUM, Management style, Reputation and System of Risk Management. 

An ideal asset allocation states that one should have 10 to 20% of his portfolio exposure in Alternative Investments. But as a rational investor one should consult his financial planner before he could finalise buying these types of product.