Key to WEALTH CREATION - Asset Allocation

Asset allocation plays a key role in every investors financial planning.

If, I get a chance to own a IPL Team "Dream Achievers'. How should I go for buying players,during auction.Should I buy all 15 team members as Fast Bowlers or All Rounders or Spinners or Hard Hitters. No, I need to make strategy looking at different options available, their pricing and my budget. According to that I will buy 7-8 good Batsman, 2-3 Spinners, Obviously a Wicket Keeper and 4-5 Fast bowlers, Possibly 2-3 of them being all rounders.

Depending on the ground conditions and opponent I decide the final team on the Jumping Japak Jumpak Jumpak. I might have 3 spinners and 2 pacers or 4 pacer and 1 spinner might send opener as Mr.Pinch hitter or Mr.Reliable. So I  need to put in place some strategy in buying the players as well as before start of the match.

Similarly in investments, all asset classes doesn't work at all the time, But perform in cycles. Hence if one were to invest all his savings in a single asset class then certainly he is inviting a big trouble for his future.As we all know world of finance is very uncertain and sticking to your asset allocation hold the key to success. 

Financial Planners uses asset allocation strategies not only to create wealth, but also to protect it during volatile times. It is not the maximisation of returns, but optimisation of returns that becomes the goal. This process plays a key role in determining the risk and return from your portfolio. Broadly speaking, the portfolio’s asset mix should reflect your risk taking capacities and goals. Financial Planners use different strategies of building asset allocations, some of them as follows :

Strategic Asset Allocation

Strategic allocation is typically the first stage in the investment process. Based on the investor’s long-term objectives, an initial portfolio is build. It is the backbone of any investment strategy. This often forms the basic framework of an investor’s portfolio. This is a proportional combination of assets based on expected rates of return for each asset class. For example, if stocks have historically given a return of 14% per year and bonds have returned 8% per year, a mix of 50% stocks and 50% bonds would be expected to return 11% per year. Strategic asset allocation generally implies a buy-and-hold strategy. Strategic asset allocation defines the boundary of risk, and it is these boundaries that help control portfolio risk.

Constant-Weighting Asset Allocation

Strategic asset allocation has its drawbacks as it entails a buy-and-hold strategy even if a change in the value of assets causes a drift from the initially established policy mix.The constant weighing strategy helps you to continuously rebalance your portfolio. For example, if gold was declining in value, you would purchase more of it to maintain its weightage and if its value increased you should sell it. There are no hard-and-fast rules for the timing of portfolio rebalancing under strategic or constant-weighting asset allocation. Most Planners advises rebalancing to its original mix when any asset class moves more than 5-7% from its original value or alternatively on semi annual basis.

Tactical Asset Allocation

Most of the Indian investor I have follows this allocation strategy without knowing risk associated with it. There are investors who constantly want to seek returns out of market opportunities that arise. Hence, they go in for short term tactical calls. Such tactical calls create room for capitalising on unusual or exceptional investment opportunities. This is like timing the market to participate in the fluctuations and volatility that arise due to market conditions. For example, shifting a part of the portfolio from large cap stocks to mid cap stocks to take advantage of the environment is a tactical call. Tactical allocations being opportunistic in nature, Investor are advised to always prefer to maintain clear time-based and value-based entry and exit points to ensure better management. Personally, I feel it is impossible to time the market on long term basis, it is something like predicting future and one wrong call can affect your financial plan drastically.

Dynamic Asset Allocation

It is for aggressive investors who want to ride momentum at times. So, if the stock market is showing weakness, investor sell anticipating a further fall. If it is going up, he buys anticipating a further rise. Here you constantly adjust the mix of assets as markets rise and fall. This is the opposite of constant-weighting strategy. As the entire portfolio is available for action, amateur investors may turn hyper active. Especially in the high volatile times, acting on all types of information can lead to high transaction costs. Also, the tax treatment of the returns turns to disadvantages if you churn your portfolio too much. 

Finally, victory of match depends on the strategy applied by captain in selecting the players as well as ground (market) conditions.

Similarly, to achieve financial goals as well as creating wealth every investor need to follow the asset allocation strategy and stick to it in different market conditions.Financial planners plays a big role in helping them to select a strategy which suits their risk profile and tries to bring in required discipline.