Asset Allocation (Definition, Examples)

What is Asset Allocation?

Asset Allocation is the distribution of wealth in various asset classes like debt, equity, mutual funds, real estate, etc for achieving long term financial goals and objectives and it depends on the risk appetite and returns expectations of the individual.

Explanation

Assets can be clubbed under several classes. The weight of each asset class is determined by the Expected Return of each class and also on the risk objective of the client. It is the most important stage of portfolio management. It is done in the planning stage of portfolio management. Each client has got a particular risk appetite. The portfolio manager’s sole responsibility is always to judge the risk appetite of a client correctly. Once the risk appetite is judged, the risk is distributed to agreed asset classes, and allocation is done as per the commitments of the client and future goals.

Asset Allocation Strategies

There are three strategies:

#1 – Asset-Based Strategy

This strategy in asset allocation only considers what the client has got that can be invested in several asset classes to generate a return. Say a client has $20 M in assets and is still working, he also has a spare Real Estate property that is worth $2M. So in this approach, the portfolio manager will try to focus on only the assets and will try to maximize return accordingly. He will think of ways to invest the $20 M and also how to use the spare property to increase wealth and so on. The $20 M he may plan to invest in Equity, Bond and other assets but not Real Estate as he already has a real estate. So his asset allocation is focused on the assets he already has. If he is already owning an asset class, then that asset class investment can be avoided. So if he has already invested $5 M in Equities then equity investment can be avoided.

#2 – Liability Driven

Liability Driven approach focuses to keep assets to mitigate liabilities of the client. Say a client is exposed to a seasonal business, so his asset allocation should be in such a way that when his business is low in generating revenue then the investments should operate in the peak so that support can be provided to him.

#3 – Goal-Driven

The goal-driven approach is the creation of Sub portfolios with different asset classes for each goal of the client. Say the client has 5 goals starting from extreme priority to low priority. So for each goal, a separate sub-portfolio will be created. If the goal is of extreme priority like education of a child, then the sub-portfolio created for it should invest in the safest assets. So its asset classes should be different secured bonds. Similarly, if the goal is of not so important, then the asset classes can be like small-cap stocks, derivative options, etc.

Example

Mr. X is planning to retire at the age of 60. Currently, he is 45 and has a net worth of $2 M. He is into government service and receives a monthly salary of $50,000. He plans to do Europe Trip at the age of 50 and is also planning to withdraw $50,000 per month after retirement. From his monthly income, he is ready to contribute $20,000 each month towards the portfolio. Mr. X loves skydiving and mentions his risk appetite to be high. Throw some light on the possible asset allocation. He doesn’t have a pension.

Solution:

Mr. X’s corpus is not so big, which will help him withdraw $50,000 per month after retirement for infinity. If the interest rate in the market during his retirement stands at 5%, then he will have to convert his $2 M to $12 M within 15 years to reach his objective of withdrawing $50,000 per month for eternity.
So to make this happen, you will have to invest the $2 M in very risky assets and if anything goes wrong, then Mr. X doesn’t have a pension to safeguard himself after retirement. So even if Mr. X has mentioned that his risk appetite is high, then also you can’t start investing in high-risk classes. The portfolio manager will have to educate the client that the goal he has is not achievable and if he really wants to achieve the goal then he will have to contribute more.
So for this kind of person, the Ideal Asset allocation should be 40% in Equity as he has 15 years of the horizon. 50% in Bonds that will keep his money safe and will help him to build a fixed corpus and 10% in Equity as he doesn’t need so much of liquidity now.

Asset Allocation Process

Step #1

Asset Allocation starts with analyzing the risk appetite of the client. A client may say that he will be able to take a maximum risk, but the portfolio manager will have to analyze him correctly and decide whether only his willingness to take risk is high or the ability to take risk is also high. After analyzing the circumstances say the portfolio manager decided that risk should be 12% and he needs a return of 15% per year to reach its goal.

Step #2

Now the portfolio manager will have to find out the Capital Market Expectation of each asset class. CME is the process of determining the Expected Return form each asset class, the Risk of each asset class and also the correlation between each asset classes

Step #3

After CME is calculated, the portfolio manager will have to use software to plot several asset classes’ weights that will give the maximum return considering different risk points. This line that is plotted is the Efficient Frontier Line.

Step #4

Now Portfolio manager will have to plot the Indifference curves of the client. These Indifference Curves are being decided considering the Risk and Return objective of clients.

Step #5

Now the portfolio manager will have to see as to where exactly the Efficient Frontier meets the Indifference Curves. The point will give the optimum allocation where you will get the exact weights that you need to put in each asset classes to get the desired return considering the risk objective is not hurt

Importance

It is the first stage of the portfolio management process, without a decision of the Asset Classes, it will not be possible for portfolio managers to decide where to invest and for how long.
Asset Allocation is done by considering the Risk Appetite of the client that is Sigma. So it helps a client to invest its money considering the risk he will be able to bear.
Each Asset Class has got unique features and the correlation between asset classes is low, so investing money in several asset classes helps to diversify the portfolio.
Investing in several asset classes helps to mitigate the unsystematic risk and only systematic risk is there.

Issues of Asset Allocation

Asset classes should be investable, which means that class should not be something that is not tradable. If the class is not tradable then you can’t invest. So when deciding which classes to invest, the class should be studied properly.
There should be a very low correlation between asset classes so that after investment the diversification benefit can be enjoyed. So if you are investing in asset classes with high correlation, then your portfolio will contain unsystematic risk.

Benefits

It helps to obtain the diversification benefit in a portfolio.
Knowing the expected return and Standard Deviation of an asset class helps to properly judge the exact amount of wealth that should be invested to reach the desired goal

Conclusion

Asset Allocation is the most important part of portfolio management. It helps to decide the class of assets that should be invested to reach the desired goal considering the desired risk. In the current finance world, it is being done by Artificial Intelligence which puts forward a set of questions to the client and makes the strategic allocation accordingly.

Asset Allocation