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.