A Fortnightly Newsletter
01st December 2011
Mutual Funds

What is Asset Allocation

The first step before buying a fund or before making any investment is analyzing the investors Risk and Return objectives and his Constraints. This is the first step in analyzing whether investments are in line with investor's objectives or not. After analyzing investor's risk and return profile and constraints asset allocation is done.

Asset allocation is the strategy used in choosing between the various kinds of possible investments, in other words, it is the strategy used in choosing in what asset classes (such as stocks and bonds) one should invest in. Asset allocation is performed in two distinct process- Strategic allocation and Tactical allocation. The first, strategic allocation, responds to the interaction of the investors long term needs or goals and long run capital market expectations. The allocation itself is typically specified in a range of percentages (e.g. a strategic allocation for domestic equity of 30% to 40%), and if the actual percentages wanders outside that range, the portfolio is rebalanced. It should be remembered that the strategic allocation is based upon the investor's long run goals and long run expectations. When the market experiences short term disruptions the investor can change the allocation for short periods and this is known as tactical allocation. The question over here is that if tactical allocation has to be performed than what is the use of strategic allocation.

The first response to this question is to provide discipline, that is, to maintain focus on objectives and constraints. Without a clearly defined strategic allocation based upon systematic risk factors, the portfolio would not reflect investor's desires with respect to risk and return. Also, over the long run, asset classes seem to respond somewhat homogeneously to systematic factors. That is, the investor can expect general classes of assets in the portfolio to respond similarly to macroeconomic factors.

Tactical allocations involve short term deviations from the strategic asset allocation in an attempt to capitalize on capital market disequilibrium. It can be accompanied by trading assets or through derivatives. In either case the process can be performed at infrequent intervals or as a part of a regular tactical allocation program that monitors market conditions, sectors and asset classes and react accordingly. An example of tactical allocation is that an investor might feel that equities are undervalued so he can buy equities and sell bonds to cash on the temporary mispricing and when the prices are in equilibrium the investor can sell equities and return to his original strategic asset allocation.

Illustration

Let's say on the basis of risk and return profiling of Mr. Rajesh his strategic allocation is-

Equities 50%
Debt 30%
Alternative investments 10%
Cash 10%
Now if Mr. Rajesh feels that equity will not perform well in next six months due to decrease in growth but bonds will perform better due to decrease in interest rates and inflation than Mr. Rajesh can change the strategic allocation of his portfolio and do a tactical allocation to cash on the mispricing in the following way-

Equities 20%
Debt 60%
Alternative investments 10%
Cash 10%
Thus with the help of tactical allocation Mr. X can take advantage of temporary mispricing by switching from equities to bonds.

Asset allocation is one of the most important steps in the investment process as it decides the return you will get from your investments so utmost care should be taken while doing asset allocation.

References:
1) www.investopedia.com › Dictionary
2) Idzorek, Thomas M., "Strategic Asset Allocation and Commodities", Ibbotson Associates, March 27, 2006
3) Wikipedia: http://en.wikipedia.org/wiki/Asset_allocation


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