Asset Allocation

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) explains asset allocation, a much-discussed topic in asset management.

Introduction

Asset allocation refers to the process of dividing an investment among different assets and, at a more integrated level, asset classes, sectors of the economy and geographical areas.

The allocation of an investor’s money across different assets can be analyzed according to different dimensions: investment objective, risk profile, and time horizon. The allocation process helps in finding a right balance between these dimensions and ultimately generates optimal returns in terms of expected return and risk. A key concept underlying asset allocation is diversification.

There are several assets in financial markets that the investor can use in his/her asset allocation. These asset classes include traditional assets like equities, bonds and cash, and alternative assets like real estates, commodities, and cryptocurrencies. Investors may also use combinations of such basic assets like mutual funds, exchange trade funds and more complex products like structured products.

Basics of asset allocation

Characteristics of investors

The characteristics of asset allocation for investors comes from its significant impact on the portfolio performance. Asset allocation decisions rely on input of the process: investment objective, risk profile, and time horizon.

Investment objective

The process of asset allocation impacts the financial objectives of the investor. If the investor has a low-risk appetite, he/she might be exposed to high degree of risk by investing in equities. Thus, such an investor should invest in safer assets such as bonds and fixed deposits to have a low-risk portfolio.

Risk Profile

The risk appetite of an investor determines the mix of different asset classes in a portfolio. Investors aiming for low risk should include a comparatively higher mix of risk less assets like bonds and real estate than equities.

Time horizon

The time horizon of an investment is also an important characteristic of the asset allocation process. Investors can either invest for a long-term time horizon or a short term depending on their investment objective.

Characteristics of assets

The characteristics of asset allocation comes from its significant impact on the portfolio performance. Asset allocation decisions can also rely on asset’s features such as: Expected returns, risk, and correlation.

Expected returns

The main focus of any investment in financial markets is to make maximum profits (returns) within a coherent risk level. Different asset classes have traditionally offered different returns, determined by their risk levels and market correlation. Generally, bonds have offered a lower long-term return as compared to the equity markets. Thus, investors aiming for higher returns should include an higher mix of these high return asset classes like equities than bonds.

Risk

Different asset classes have different characteristics and thus, different risk levels. The bonds market is generally considered less risky as compared to the equity markets. Thus, investment in bonds exposes the investor to a lower degree of risk than investing in equities.

Correlation

Different asset classes differ in their correlation which is also an important factor while deciding the optimal portfolio mix. It is possible that one asset class might be increasing in value whereas the other may be decreasing in value. For example, if the bonds markets are trending upwards, it is possible that the equity markets might be falling. Thus, by having an optimal mix of these asset, the investor can be compensated for the losses in equity markets with gains in the bond markets. Degree of correlation plays an important role in protecting the investor from downfalls in one asset class by compensating the losses with gains in other asset class.

Asset allocation processes

The asset allocation processes can be divided into two types: strategic asset allocation and tactical asset allocation.

Strategic asset allocation

Strategic asset allocation is a long-term investment strategy driven by long term market outlook and fundamental trends in the market. The strategy follows a top-down approach, and the investor generally looks at the macro level trends followed by trends in different asset classes to take the investment decisions. The investor following this allocation type generally has a pre-defined return expectation and risk tolerance levels and practices diversification to lower the risk. These investments are made in traditional assets like equities, bonds and cash assets but can also include alternative assets.

The investor follows a fixed objective which remains unchanged throughout the investment horizon. This can include a policy mix of investing 40% of portfolio in equities, 30% in bonds, 10% in real estate and remaining 20% in cash. As opposed to the tactical asset allocation, strategic asset allocation involves periodical rebalancing of the portfolio to get higher returns. If the investor diverges from the fixed objective, he/she must rebalance the portfolio to unify it with the original mix.

This strategy is suited to new or irregular investors who seek to generate returns at par with the market returns. The standard asset class suited for this strategy includes mutual funds, ETFs, blue-chip equities, bonds, fixed deposits, and real estate.

Tactical asset allocation

Tactical asset allocation involves actively investing in asset and securities to enhance portfolio returns by constantly rebalancing the portfolio and exploiting market anomalies. Even though the investor is following strategic asset allocation, the financial markets often present attractive buying or selling opportunities which can be exploited by tactical asset allocation to attain even higher returns. These opportunities can involve cyclical deviations in businesses, momentum trends and exploiting under valuations. However, these deviations from strategic allocation are often done carefully so as not to hinder the long-term objective.

The investment horizon in this strategy can be short or long depending on the investor’s preferences. However, the investor tries to generate higher returns and constantly rebalances the portfolio to achieve these returns by exploiting the market inefficiencies. Tactical asset allocation requires good understanding of the financial markets and is generally practiced by experienced investors with moderate to high risk tolerance.

Asset allocation over time

The investors deciding on the asset allocation process over time can follow different approaches, which includes:

Passive management: the buy-and-hold approach

In a passive asset management, the aim of the investor is to replicate the performance of a benchmark index. These investors can have lower risk appetite; thus, replications help to reduce the risk exposure for them. The investors following a passive approach can buy the individual components of the index by applying similar weights and invest with a moderate to long term time horizon in mind. The suitable asset classes for such investors can include mutual funds, exchange traded funds, index funds, etc.

Active management: dynamic asset allocation

In active asset management, the aim of the investor is to maximize the returns on the portfolio by actively investing in asset classes. The portfolio mix is frequently adjusted to capitalize on the short-term trends across different asset classes. The rebalancing decisions are based on business and economic cycles, momentum trends, relative valuations across different asset classes and macro factors like inflation, GDP growth, etc. The investor tries to beat the benchmark indices by dynamically trading in different asset classes and exploiting the market inefficiencies. They generally have high risk appetite and good knowledge about different asset classes. The suitable asset classes for such investors can include equities, commodities, and bonds.

Useful resources

US Securities and Exchange Commission (SEC) Asset Allocation

Related Posts

   ▶ Youssef LOURAOUI Systematic risk and specific risk

   ▶ Youssef LOURAOUI Portfolio

About the author

Article written in July 2022 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).