Allocate your assets

GUEST COLUMN

Madness overtakes even rational individuals when a stock market boom is on. There are many mistakes that investors often commit during a boom.

Among the worst kind of mistakes is the indiscriminate liquidation of investments in the debt segment and other asset classes in favour of further equity exposure.

Their line of thought is simple: while debt and other asset classes are delivering returns in the vicinity of 8 per cent, equity is delivering returns in the vicinity of 50 per cent plus.

But they fail to comprehend that in a worst case scenario, debt investments might still deliver around 6 per cent, but equity investments can easily erode their capital.

Asset allocation is the most important factor in determining the return on your investments. It is based on the theory that the type or class of security you own is much more important than the particular security itself. It is a way to control risk in your portfolio.

The risk is controlled because the six or seven asset classes in a well-balanced portfolio will react differently to changes in market conditions such as inflation, rising or falling interest rates, market sectors coming into or falling out of favour, a recession, etc.

Asset allocation should not be confused with diversification. Suppose you diversify by owning 30 or even 50 different stocks. You really haven't done anything to control risk in your portfolio if all those stocks come from only one or two different asset classes - say, blue chip stocks (which usually fall into the category known as large-cap stocks) and mid-cap stocks.

Those classes will often react to market conditions in a similar way - they will either go up or down after a given market event. This is known as 'correlation.' Hence, beware of those investment 'experts' who advise you to "stick only to the best stocks (read as blue-chip stocks )".

There are two ways in which investors can undertake an asset allocation exercise. Traditional asset allocation - also referred to as strategic asset allocation - uses a fixed ratio to distribute assets among different investment categories.

The ratio is typically determined using parameters such as an investor's age, financial objectives or risk tolerance. While this approach reduces risk, it does not take advantage of market conditions and leaves significant portions of the portfolio vulnerable.

The more the categories used to diversify risk, the more return tends to be reduced compared to the best performing segments of the market.

Dynamic asset allocation - also referred to as tactical asset allocation - is an active investment approach that distributes assets among the different assets classes in domestic and international equity and bonds investments and money markets.

That distribution is adjusted on a continuing basis in response to market and economic conditions, based on the perception of the return potential and relative risk of each asset class. Dynamic asset allocation seeks to reduce risk through diversification among different investment categories.

Using dynamic asset allocation, however, investors select or weight investments based on those categories with the greatest perceived potential for superior returns, given current market conditions.

As the market moves, however, it is not always realistic to have exactly the same asset mix at all times. There may be a need for flexibility to deviate from the determined strategy to take advantage of market opportunities. Therefore, the investor must decide on tactical boundaries.

For example, considering a hypothetical portfolio the proportion of bonds in the initial strategic portfolio is 40 per cent with tactical boundaries between 35 per cent and 45 per cent. These boundaries enable you to carry out tactical asset allocation.

Strategic asset allocation decisions are based on long-term expected returns and estimations that can significantly vary in the short to medium term. These variations can impact the return of your portfolio.

Because strategic asset allocation is usually reviewed annually, some shorter-term adjustments are sometimes necessary. This is where the tactical asset allocation strategy starts.

Tactical asset allocation is used to realign the expected return and risk to the long-term strategy. It is also referred to as portfolio optimisation. Tactical changes are designed to increase the portfolio returns or to reduce its risk level.

Tactical asset allocation can be applied in different ways. Generally, it is dictated by the opportunities offered by the marketplace. One example is sector rotation. Sector rotation is the belief that some sectors in the economy will outperform other sectors.

The sectors that are expected to perform better are given additional weight in the asset allocation model. Tactical boundaries can also be defined within which the investor will operate when under-weighting or over-weighting the different asset categories in reaction to short- to medium-term market and economic conditions.

There are two main ways of carrying out tactical asset allocation. The one you choose depends on your knowledge of the market and your ability to follow it closely. Active management is a money management approach that is set up to outperform the market by applying independent investment judgment.

With active management, investors manage their portfolios by selling or buying various assets. Such transactions are based on short- and medium-term expectations and differ from the expectations used for the strategic asset allocation.

Active management assumes that market forecasts are possible. The percentage invested into the different categories is adjusted to the best-assumed return conditions. Active tactical asset allocation is sometimes called market timing.

If intermediate and short-term forecasts are made accurately, active tactical asset allocation has the potential to enhance returns. However, bad market timing may have an important negative impact on returns.

In a passive investment strategy, the investor decides not to actively change the portfolio, leaving market developments to influence the result. One approach, for example, is to buy and hold a well-diversified selection.

In that case, the investor tries to either pursue the position defined in the strategic asset allocation (which means regular changes to the number of shares to maintain the desired asset class ratios as the market values change) or simply buy and hold the positions.

Opting for a passive management of tactical asset allocation often results in respectable results, especially in the long term if the historical trend in the markets is upward. However, this strategy assumes that the market is reasonably efficient, and that it is not possible to 'outsmart' it in the long run by buying selected shares.

Many portfolio managers and private investors overestimate their own skills and tend toward high-risk investments. Therefore, they buy more stocks and easily break out of the tactical boundaries. But the risk often rises disproportionately against returns.

Because markets tend to rise and fall without any regard to investor objectives, the percentages allocated to specific asset classes over time may no longer be in sync with your initial desires. It's necessary to periodically check your portfolio's asset allocation and ensure it's in line to reach your goals.

Whereas one can ride the equity tide as it soars, a prudent asset allocation mix would ensure against your being washed away when the tide begins to ebb.

(The author heads Lotus Strategic Consultants, Mumbai, and can be contacted at ceolotus@hotmail.com.)