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Asset Allocation - The Strategic Tool for Financial Planning

In the previous article we have discussed the principles of financial planning. Asset Allocation is a very important part of Financial Planning. Financial Planning gives us a clear idea about how long to go on investing and how much to investment. The third question is how long to go on investing and how much to invest. The third question is where to invest, or which kind of asset to invest in. This question brings in the third principle of financial planning –Allocation of investment Assets.

Asset allocation means determining the percentage of your investments to be held in equities, bonds and money market/cash instruments. It has been observed that over 94% of the returns on a managed portfolio come from the right levels of asset allocation between stocks and bonds /cash. So any financial planning for an investor must determine a suitable asset allocation plan.

Asset Allocation Principles

Following are the major asset allocation principles that will help to allocate / deploy your assets efficiently.

• Benjamin Graham’s 50/50 Balance
• 50/50 Portfolio of Mutual Funds
• Strategic Asset Allocation
• Fixed vs. Flexible Asset Allocation
• Tactical Asset Allocation

Benjamin Graham’s 50/50 Balance

We can with the fundamental asset allocation advice given by one of the stalwarts of investment planning, Benjamin Graham, who recommends 50/50 split between equities and bonds, the common sense approach to start with. When the value of equities goes up, balance can be resorted by liquidating part of portfolio, and vice versa .This is the basic defensive or conservative investment approach. Benefits include not being drawn into investing more into equities in rising markets. Both the gains and losses will be limited .But it is good to get about half the returns of a rising market and to avoid the full losses of a falling market.

0/50 Portfolio of Mutual Funds

Graham’s approach can be translated into reality by holding different kinds of portfolios of funds. We suggest the following combinations :

1. A Basic Managed Portfolio 50% in diversified Equity ‘Value’ Funds
25% in a Government Securities Fund
5% in High Grade Corporate Bond Funds
2. A Basic Indexed Portfolio 50% in Total Stock Market /Index Fund
50% in a Total Bond Market Portfolio
3. A Simple Managed Portfolio 85% in a Balanced 60/40 Fund
15% in medium term Bond Fund
4. A Complex Managed Portfolio 20% in diversified equity fund
20% in aggressive growth fund
10% in specialty funds
30% in long-term bond fund
20% in short-term bond fund
5. A readymade Portfolio single index Fund with 60/40equity/bond holdings

Strategic Asset Allocation

Graham’s 50/50 is the basic asset allocation. We recommend adjusting the percentages for each group in terms of their lifecycle phases. During the Accumulation Phase, an investor would be building assets by periodic investments of capital and reinvestment of all dividends received. During the Distribution Phase, he will stop adding asset and start receiving dividends as income. Considered in conjunction with the investor’s age he recommends the following strategic allocation :

Phase Equity/Debt
Older Investors in Distribution Phase 50/50
Younger Investors in Distribution Phase 60/40
Older Investors in Accumulation Phase 70/30
Younger Investors in Accumulation Phase 80/20

In other words, younger investors can be more aggressive and let the magic of compounding work for them, while older investors take a more conservative approach. Similarly, investors in the Accumulation Phase can take greater risk than those who need income and are in their Distribution Phase. Debt portion of an investors take a more conservative approach. Similarly, investors in the Accumulation Phase can take greater risk than those who need income and are in their Distribution Phase. Debt portion of an investor’s portfolio should be equal to his age. So let a 30-year –old investor make 70/30- asset allocation, and at age 50 let him balance it out. And so on.

Fixed vs. Flexible Asset Allocation

Once a strategic asset allocation has been decided, it should be re-balanced periodically to benefit from market movements and as investor’s circumstances, returns obtained or time horizon change.

A fixed ratio of asset allocation means that balance is maintained by liquidating a part of the position in the asset class with the higher return and reinvesting in the other asset with lower return. This is not what investors normally do. They tend to increase their equity position when equity prices tend to climb up and vice versa. But this and lets approach is more disciplined him book profits in rising markets and increase holdings in falling markets.

A flexible ratio of asset allocation means not doing any re-balancing and letting the profits run. As stocks and bonds will give different returns over time, the initial asset allocation will change, generally in favour of equity portion as its return would be higher than bond portion. The distribution-oriented investor will find his initial ratio change in favour of equities much more than the accumulation-oriented investor.

As an example Rs.200 invested equally in stocks and Bonds, with returns being 10%& 7% at the end of 10 years, for accumulating investors, it will be 57/43 ratio at the end of 20years the ratio will be 63/37. But for the distribution- receiving investor, 10 years will see 66/34 ratio and 20 years will see 79/21 ratio.

Note that the investor who takes out the income from debt funds without reinvesting, stands to automatically increase his equity part of the portfolio much more significantly the accumulating investor, since his debt capital remains fixed. If stocks continue to return more than bonds, then a fixed ratio is better than variable ratio. If bond returns are close to equity market returns, then the variable to ratio may work better. The answer depends upon whether one can really forecast the future. It is logical to assume that stocks will give higher returns than bonds, so fixed ratio approach to asset allocation is better at least in bull markets.

Tactical Asset Allocation

Despite the difficulty of forecasting, people do it. Fund managers themselves change their asset allocation percentages in the light of their views on the future movements in the asset prices. They seek extra returns by taking bets on relative valuations of different assets. For example, you may invest in the small- company more than the large-company shares, or prefer value stocks over growth stocks. Further, you may change the equity/debt mix itself in favour of where you expect greater returns. These tactical changes in asset allocation within the overall percentage holding or in the strategic ratio itself may yield extra returns, if the bet is right. But, clearly, there is no guarantee.

Can we get Increased Return without Increased Risk?

The above discussion assumes that you cannot expect increased returns without increased risks. But there is a way in which mutual fund investing can offer higher returns, which come without higher risk level .This is the issue of costs of investing. A fund that earns a higher return than another can still give lower net returns, if its expense ratio or loads are higher. If the first funds higher return is on a riskier portfolio, the investor gets a higher risk and a lower overall return. Choose a fund that holds a lesser-risk portfolio, and has lower expense, impact on amounts distributed to investor. A fund that holds higher risk assets will have a risk premium build into its return. But its costs can act as a penalty for investors. While doing the invest planning for your investor, remember to either hold the similar funds in terms of both risk level of the portfolio and fund costs, or chose the right risk level for the investor and then the fund with less “cost penalty”.

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