Investment Planning

(Asset Allocation -
Concepts & Practices)

MAHENDRA K PATIDAR
PGDMBIF
Institute of Public Enterprise, Hyderabad
Super Classes of Assets

 Capital Assets
 Assets that can be used as Economic
Inputs
 Assets that are a store of value
 Real Estate
Capital Assets
 Capital assets are defined by their claim on the future
cash flows of an enterprise. They provide a source of
ongoing value. These assets are usually valued as the
net present value of their expected returns.
 Besides stocks and bonds, PE funds, Hedge Funds and
Credit Derivatives belong to this category/ class of
assets.
 PE funds and Hedge Funds are different from the
traditional stock- and-bond investments only because of
the trading strategy they use, is different.
 Mutual Funds, Exchange Traded Funds also belong to
this super asset class
Assets that can be used as
Economic Inputs
 These are consumable or transferable assets which can
be converted to another form of asset.
 Generally, this class of asset consists of physical
commodities, grains and metals etc.
 These assets are used as economic inputs to produce
other assets, like automobiles, appliances, new homes
etc
 These assets can not be valued using a net present
value computation – as they do not produce a stream of
cash flow – there may not be any capital appreciation
also.
 This class of asset, however offer excellent diversification
opportunity, vis-à-vis capital assets.
Assets that are a Store of
Value
 Art is considered the classic asset that store value. It
does not belong to the two classes of assets discussed
earlier. Art requires ownership and possession. Its value
can only be realized through sale and transfer of
possession. Antics also belong to this class of assets.
 There is no rational way to gauge whether the price of an
art would increase or decrease because its value is
derived purely from subjective ( and private) visual
enjoyment that the right of ownership conveys.
 Gold and precious metals are another example of a store
of value class of asset. In developing countries these
assets are used to maintain wealth as they do not have
adequate access to other forms of financial assets.
However the dividing line can
become blurred……
 Gold can be used by jewelry manufacturers
 Art pieces can be leased to star hotels for
decoration to generate a stream of cash flow
(lease rentals)
Real Estates
 Real estate is a distinct class of asset.
 It was a major asset class for most individuals even
before stocks and bonds came into existence.
 For most individual investors, even today, real estates is
a major class of asset.
 It is therefore known as a Fundamental Asset Class that
should be included within every diversified portfolio.
What are Alternative Assets?

 Alternative assets are just alternative

investments within an existing class.
 They may employ alternative investment
strategies like Hedge Funds and P E
Funds.
 Four major alternative assets are :
Hedge Funds, PE Funds, Commodity
Futures and Credit Derivatives
Asset Allocation

 Asset Allocation is generally defined as

the allocation of an investor’s portfolio
across a number of asset classes.
 It is an investment profile that provides a
framework for constructing a portfolio
based on measures of risks and return.
Asset Allocation Concepts

 Asset Classes and Asset Allocation

 Strategic vs. Tactical Allocation
 Efficient vs. Inefficient Asset Classes
 Asset Location vs. Trading Strategy
Asset Classes & Asset
Allocation
 Traditionally asset allocation involved four classes of
assets: Equity, Fixed Income, Cash and Real Estate.
 Within each class, the assets could further be divided into
subclasses. For example Stocks can be divided into
large-cap, mid-cap, small cap stocks, Fixed income
Securities can be divided into Treasury Bills, Bonds,
Bank Fixed Deposits etc.
Strategic vs. Tactical
Allocation
 Strategic allocation of resources is normally applied to
fundamental asset classes like equity, fixed income, cash
and real estate. These are basic asset classes which
must find place in any diversified portfolio. Strategic asset
allocation is concerned with the long term asset mix and
designed to accomplish long-term goals.
 Tactical asset allocation is short-term in nature. This is
used to take advantage of current market conditions that
may be more favorable to one asset class over another.
The goal of tactical asset allocation is to maximize return.
Strategic vs. Tactical
Allocation
 Tactical asset allocation is for the ability to diversify within
an asset class. Here alternative assets add value.
Alternative assets do not hedge the returns of
fundamental assets classes, but try to expand them.
Consequently, alternative assets should be considered
as part of a broader asset class.
Efficient vs. Inefficient Asset
Classes
 Stock and bond markets are generally considered to be
efficient, though the degree of efficiency vary. Efficiency
is a parameter which measures to what extent all the
publicly available information about a corporation found
reflection in price of its securities.
 In contrast, with respect to alternative assets, information
is very difficult to acquire. Most alternative assets are
privately traded. Investment in alternative assets are less
liquid.
Asset Location vs. Trading
Strategy
 Economic exposure( risk and return) associated with
mutual funds is defined primarily by where the mutual
fund invests, viz., mid-cap fund, infrastructure fund,
diversified equity fund etc.
 In contrast to this, hedge funds’ economic exposures are
defined more by how they trade. That is, a hedge fund’s
risk and return exposure is defined more by a trading
strategy within an asset class than it is defined by the
location of the asset class.
A Guide to Portfolio
Construction
 In today's financial marketplace, a well-
maintained portfolio is vital to investor's success
As an investor, one need to know how to
determine an asset allocation that best
conforms to his / her personal investment goals
and strategies.
 As an individual, your portfolio should meet
your future needs for capital and give you
peace of mind.
 Construction of portfolio must take into account
effects of risk – return trade off .
Factors to be considered for
Portfolio Construction
 Age
 Family Status
 Capital Available
 Time left for Accumulation
 Future Capital Needs – Expected
Returns
 Risk Profile – Risk Tolerance
 Available Asset Classes
Diversification of Portfolio as a
measure for reducing Risk
 Diversification can eliminate most, if not all , of the
nonsystematic / specific risks of individual securities, leaving the
portfolio with only market related risk.
 However, one observes a diminishing marginal diversification
effect through the addition of new securities to the portfolio.
 Fund managers tend to have a minimum of 15 stocks in their
portfolio, but hold more securities if the overall value of fund size
is higher.
 Certainly by the time 15 stocks have been included, a very great
portion of specific risks of individual securities have been
diversified away as a result of differing behavior of securities
given different market conditions.
 Alternative assets are used for effective diversification of a
portfolio
Diversification Effect
Expected Portfolio Variance

Number of Securities
6 12 18 24 30
Steps for Portfolio
Construction
 Consider all the factors for portfolio construction ( age etc.)
 Decide all the asset classes and subclasses which should find a
place in the portfolio.
 For Stocks, decide Sector wise Market-cap limits
 For bonds, decide share of Government & Corporate Bonds
 Decide Stock Picking & Bond picking Strategies
 Decide on shares of Mutual funds and Exchange Traded Funds
and their picking strategies
 Decide on other fundamental and alternative assets
 Arrange for contingencies – Cash or near cash instruments
 Balance the portfolio by fixing weightages
 Rebalance from time to time to get better results ( risk-return
profile)
Risk – Return Profile of Assets

Risk
Small-cap
Mid-
cap

Large-Cap

Corporate Bonds

Government Securities

Return
Risk Pyramid

Summit options High Risk

futures

Middle Real Estates

Equity Mutual Fund
Large, Mid &Small Cap

High Yielding Bonds / Debts

Base Government Bonds / Debts
Money Market, Bank Deposits
Cash & Cash Equivalents Low Risk
Risk Pyramid
 Base of the Pyramid– The foundation of the pyramid represents the
strongest portion, which supports everything above it. This area should
be comprised of investments that are low in risk and have foreseeable
returns. It is the largest area and composes the bulk of your assets.
 Middle Portion– This area should be made up of medium-risk
investments that offer a stable return while still allowing for capital
appreciation. Although more risky than the assets creating the base,
these investments should still be relatively safe.
 Summit– Reserved specifically for high-risk investments, this is the
smallest area of the pyramid (portfolio) and should be made up of
money you can lose without any serious repercussions. Furthermore,
money in the summit should be fairly disposable so that you don't have
to sell prematurely in instances where there are capital losses.
Matching Risk Tolerance to
Personality
 Having a good understanding of an investor's risk tolerance is crucial to
any successful advisor/client relationship. It is also a key component of
any good investment policy statement. Investment advisors usually
explore things like age, size of investment portfolio, expected retirement
date and future earnings and financial obligations to gauge an investor's
risk tolerance. These quantifiable aspects can tell us a lot about an
investor's ability to take investment risk, but what about his/her
willingness? Personality profiling can help facilitate discussions with
investors about risk tolerance and can give one insight into
investment strategies that may fit their psychological profile. The first step
in personality typing is to understand the investor's personal background.
Interviewing an investor about their life experiences, inherited behavioural
traits, career paths, and their current investment portfolio can tell a lot
about their willingness to take risk and whether or not they have a
tendency to make emotional decisions regarding their investments.
Matching Risk Tolerance to
Personality
 Lower Willingness to Take Risk
Cautious investors make decisions based primarily on feelings and are
very sensitive to investment losses. Fear drives their investment decision
making process. They have trouble making proactive decisions regarding
their investments and do not trust the advice of others. For this reason,
their portfolios usually have low turnover and include mostly safe
investments. Possible examples of investors that tend to have cautious
personalities might include retired elementary school teachers and elderly
widows.
 Methodical investors follow a disciplined, mechanical investing strategy.
They make investment decisions based on hard facts and have the
tendency to nitpick about small details. They rely heavily on investment
research and are not emotional about their investment decisions. They
tend to be disciplined investors which can cause them to have a lower risk
tolerance. Possible examples of investors that tend to have methodical
personalities could include architects and engineers.
Matching Risk Tolerance To
Personality
 Higher Willingness to Take Risk
Spontaneous investors make investment decisions based on feelings and
make them frequently. They are always second guessing themselves and
the advice of others and often chase investment fads. For this reason, their
investment portfolios usually exhibit high portfolio turnover and may include
riskier investments. Possible examples of investors that tend to have
spontaneous personalities might include a commission-based salesperson
or a young trust fund heir.
 Individualist investors make decisions based on hard facts and do not
second guess their investments often. They exercise independent thinking
and put a great deal of trust in their investment research. For this reason,
they are usually less risk averse than others. Individualist investors are
usually self-made and hard working. Possible examples of investors that
tend to have individualist personalities could include a small business owner
or an upper level manager in a large corporation.
Matching Risk Tolerance to
Personality
 When dealing with individual investors, building a truly customized
investment portfolio involves a good understanding of both their ability
and willingness to take risk.
What is the difference between risk
tolerance & risk capacity ?
 Risk tolerance and risk capacity together help to determine the amount of
risk that should be taken in a portfolio of investments.
Risk Tolerance
Risk tolerance is the amount of risk that an investor is comfortable taking, or
the degree of uncertainty that an investor is able to handle. Risk tolerance
often varies with age, income and financial goals. It can be determined by
many methods, including questionnaires designed to reveal the level at
which an investor can invest, but still be able to sleep at night.
Risk Capacity
Risk capacity, unlike tolerance, is the amount of risk that the investor "must"
take in order to reach financial goals. The rate of return necessary to reach
these goals can be estimated by examining time frames and income
requirements. Then, rate of return information can be used to help the
investor decide upon the types of investments to engage in and, the level of
risk to take on.
What is the difference between risk
tolerance & risk capacity ?
 Balance of Risk
The problem many investors face is that their risk tolerance and
risk capacity are not the same. When the amount of necessary
risk exceeds the level the investor is comfortable taking, a
shortfall most often will occur when it comes to reaching future
goals. On the other hand, when risk tolerance is higher than
necessary, undue risk may be taken by the individual. Investors
such as these sometimes are referred to as risk lovers
 Risk Return Balancing-
Strategies

Risk Return Balancing Strategy
Type of Equity (%) Fixed Income Cash &
Portfolio (%) Equivalent
Conservative 15-20 70-75 5-15

Moderately 35-40 55-60 5-10

Conservative
Moderately 50-55 35-40 5-10
Aggressive
Aggressive 65-70 20-25 5-10

Very 80-100 0-10 0-10

Aggressive
Wealth Cycle of an Investor
 Accumulation Stage : Investor builds wealth to meet financial
goals which are sometimes away. Objective in this stage is that
of long term wealth accumulation.
 Transition Stage : In this stage one or more of the goals need to
be fulfilled. Some amount of liquidity needed for children’s
education, marriage etc.
 Reaping Stage : Stage in which accumulated wealth would be
used to fulfill goals, may be at retirement stage.
 Inter Generational Transfer : Sharing of wealth with near and
dear ones by estate planning.
 Sudden Wealth Surge: May be due to inheritance, sudden
increase in value of investments etc. Extra wealth need to be
appropriately invested.
Asset Allocation Strategies
 Establishing an appropriate asset mix is a dynamic
process, and it plays a key role in determining portfolio's
overall risk and return. As such, portfolio's asset mix
should reflect one’s goals at any point in time. There are
a few different strategies for establishing asset
allocations, and here we can outline some of them and
examine their basic management approaches.
Asset Allocation Strategies
 Strategic Asset Allocation
 Constant Weighing Asset Allocation
 Tactical Asset Allocation
 Dynamic Asset Allocation
 Insured Asset Allocation
 Integrated Asset Allocation
Asset Allocation Strategies
 Strategic Asset Allocation : Strategic asset allocation is a
method that establishes and adheres to what is a 'base policy
mix‘, which is maintained in the long run. It is a passive strategy.
It is a buy-and-hold strategy.
 Constant Weighing Asset Allocation :With this approach, you
continually rebalance your portfolio. For example, if one asset
were declining in value, you would purchase more of that asset,
and if that asset value should increase, you would sell it. There
are no hard-and-fast rules for the timing of portfolio rebalancing
under strategic or constant-weighting asset allocation. However,
a common rule of thumb is that the portfolio should be
rebalanced to its original mix when any given asset class moves
more than 5% from its original value.
Asset Allocation Strategies
 Tactical Asset Allocation: Over the long run, a strategic asset
allocation strategy may seem relatively rigid. Therefore, you
may find it necessary to occasionally engage in short-term,
tactical deviations from the mix in order to capitalize on unusual
or exceptional investment opportunities. This flexibility adds a
component of market timing to the portfolio, allowing you to
participate in economic conditions that are more favourable for
one asset class than for others. Tactical asset allocation can be
described as a moderately active strategy, since the overall
strategic asset mix is returned to when desired short-term
profits are achieved. This strategy demands some discipline,
as you must first be able to recognize when short-term
opportunities have run their course, and then rebalance the
portfolio to the long-term asset position.
Asset Allocation Strategies
 Dynamic Asset Allocation :Another active asset allocation strategy is
dynamic asset allocation, with which you constantly adjust the mix of
assets as markets rise and fall and the economy strengthens and
weakens. With this strategy you sell assets that are declining and purchase
assets that are increasing, making dynamic asset allocation the polar
opposite of a constant-weighting strategy. For example, if the stock market
is showing weakness, you sell stocks in anticipation of further decreases,
and if the market is strong, you purchase stocks in anticipation of continued
market gains.
 Insured Asset Allocation :With an insured asset allocation strategy, you
establish a base portfolio value under which the portfolio should not be
allowed to drop. As long as the portfolio achieves a return above its base,
you exercise active management to try to increase the portfolio value as
much as possible. If, however, the portfolio should ever drop to the base
value, you invest in risk-free assets so that the base value becomes fixed
Asset Allocation Strategies
 Integrated Asset Allocation:With integrated asset allocation you
consider both your economic expectations and your risk in
establishing an asset mix. While all of the above-mentioned
strategies take into account expectations for future market
returns, not all of the strategies account for investment risk
tolerance. Integrated asset allocation, on the other hand,
includes aspects of all strategies, accounting not only for
expectations but also actual changes in capital markets and
your risk tolerance.
 Conclusion :Asset allocation can be an active process in varying
degrees or strictly passive in nature. Whether an investor
chooses a precise asset allocation strategy or a combination of
different strategies depends on that investor's goals, age,
market expectations and risk tolerance.
Crux of Successful Investment
Planning
 Matching the Tools and Strategies to the Personal Profile
of the Investor

Tools Strategies
Investment Vehicles Asset Allocation and
Trading Strategies

Personal Profile
Goals, Expectation of
Returns, Risk Tolerance
& Risk Capacity
Thank You