In the last article we had discussed Financial Planning and its need. One of the keys to making a financial plan is to carry out "Asset Allocation" based on:

  • Financial Goals
  • Risk Taking Capacity
  • Risk Appetite

Let's first try and understand what Asset Allocation is:

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.

Asset allocation means investing an individual's assets to meet a financial plan. It is broadly divided 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.

Why do you need 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.

As per the fundamentals 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 the 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.

Types of Asset Allocation Strategy

We can broadly classify Asset Allocation Strategy into two parts:

Strategic asset allocation (SAA)

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

Tactical asset allocation (TAA)

It aims to take advantage of perceived inefficiencies / imperfections in asset pricing in the short-term, to extend arbitrage opportunities between two imperfect markets. The aim is to enhance returns in the shorter term.

Which asset allocation strategy to implement will depend on the 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, since TAA accounts for these assumptions in shorter term.

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, this 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

This is a method of portfolio re-balancing in which the investor sets a floor value of his or her portfolio, and allocates assets accordingly. The two asset classes used in CPP are major portion of equity dominated assets 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.

For example:

One decides that 20% is the maximum "loss" possibility, the multiplier value will be (1/.20), or 5.

Assume 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 a period of time.

It is imperative to constantly review the allocations made, and also re-balancing the portfolio in order to keep them in line with the goals set and risk apatite ascertained.

Licensed content from: https://wealth-monitor.com/features/wm-in-the-classroom/asset-allocation-and-its-role-in-financial-planning/. The views expressed here are those of the authors and do not necessarily represent or reflect the views of Citibank UAE