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Asset Allocation - Importance

There are two main types of investors: Individual/Retail and Institutional. Both these types of investors invest their money with a view to attaining specifc investment objectives.

For an institutional investor it is likely to be the growth of the fund they are sponsoring. For an individual investor it is often the building of their nest egg that's expected to meet their financial needs during retirement or any other life goal such as funding for their children's education.

Both these types of investors will need to have a systematic approach to managing their money to reach their goal and here is where asset allocation comes into picture as a dominant factor.

Numerous studies have revealed that it is the effectiveness of the asset allocation strategy that plays a very important role in helping the investor attain their investment objective.

Asset Allocation, from an individual investor's perspective, involves determining how much money to allocate to a given asset class among a wide variety of asset classes available taking into account their risk profile and the time horizon within which they expect to reach their investment objective.

As one can see, in an asset allocation approach, more importance is given to the asset class rather than the individual security that belongs to the asset class. This distinction is vital to understanding why asset allocation is considered the most important factor in determining portfolio returns.

The Asset Allocation Process

From an individual investor's point of view, the overall asset allocation approach can be broken down into a series of steps as below:

  • Ascertain the investor's goals or objectives and the time horizon within which these goals will need to be attained
  • Evaluate the investor's risk profile with specific understanding of their risk tolerance
  • Develop an investment policy specific to meeting the investor's profile
  • Develop a portfolio that suits the investor's risk profile and time horizon by choosing the appropriate asset classes and proportion in which they will be invested in
  • Employ investor's capital in this portfolio and monitor it by periodic rebalancing

Major Asset Allocation Approaches

Broadly, asset allocation has at least two major dimensions: Strategic and Tactical.

Both these dimensions are important as each has its unique importance. Right at the outset, a strategic approach to allocating investor's assets will need to be taken. This strategic approach takes its inputs from the investor's needs, risk preferences and the critical factor the investor's time horizon. If an investor has a need for capital invested to be taken out in only 2 years allocating that capital to risky assets is highly improper.

Soon after a strategic plan for the asset allocation is devised, a tactical approach will need to be built.

Tactical decisions are short term decisions that take into consideration the near term factors that determine behavior of an asset class. For example, if interest rates are likely to rise in the near term tactical asset allocation will try to reduce exposure to bonds in general while allocating a portion of such a bond allocation in securities that help to keep pace with inflation. This is a tactical move that still fits into the strategic allocation plan of keeping an investor's capital allocated to bonds.

Asset Class Weights

The most difficult part of the asset allocation process from a money manager point of view is to determine the proportion of money that's to be invested in a specific asset class on a tactical perspective.

Investors who don't carry out this task well often end up with an underperforming portfolio. Choosing an asset class and its weight is not an exact science and many factors including quantitative and qualitative contribute to this decision. This is one important reason why a broader market index such as the S&P 500 is very difficult to outperform in the long run.




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