Tuesday, December 13, 2011

Asset Allocation: Key to Profitable Investments

The most important step before making any investments is analyzing risk and return objectives and whether the investments comply with investor’s objectives. Once the analysis of risk and return objectives is done, asset allocation is next on the list. Asset allocation is an investment strategy used to choose the asset classes in which an investor should invest money in. It deals with adjusting the percentage of asset classes (such as stocks and bonds) in an investment portfoliodepending on the investor’s goals and investment time-frame. Asset allocation plays an important role in determining returns and can be done using two major methods: strategic allocation and tactical allocation. Strategic asset allocation is based on investors’ long term goals and market expectations. It proportionally combines asset classes based on the different expected rates of return for each asset. It is ideally specified in a range of percentages and the investment portfolio is rebalanced if the actual percentages digress outside the range. Strategic allocation depends upon investor’s long term goals and expectation but if there are short term market disruptions, the investor can re-adjust the asset allocations for a short period. This deviation from the relatively rigid strategic allocation is called tactical allocation. Tactical allocation helps to capitalize on exceptional investment opportunities given to its flexibility in investment portfolio. This gives rise to one question in everyone’s mind: why to use strategic allocation iftactical allocation has to be performed. Well, strategic allocation is important in order to provide discipline and retain focus on objectives and constraints. An investment portfolio would lack investor’s expectationswith respect to risk and return if one does not have a well-defined strategic allocation in place. Strategic allocation is based upon long run systematic risk factors.


Therefore, with strategic allocation, an investor can expect asset classes to respond similarly to all macroeconomic factors. Tactical allocations capitalize on capital market disequilibrium by rebalancing aninvestment portfolio. The process can also include trading assets or derivatives. For example, if an investor feels that equities are undervalued, he can


Equities
50%


Debt
30%
Alternative investments
10%
Cash
10%

buy equities and sell bonds and profit from the temporary market conditions. Likewise, when the prices are in equilibrium, the investor can sell equities and adhere to his original strategic asset allocation. Let us take a look at Mr. A’s strategic asset allocation on the basis of his risk and return objectives. If Mr. A feels that equities will not be profitable in the coming months and bonds are likely to perform better due to decrease in interest rates and inflation, he can do a tactical allocation to capitalize on the temporary mispricing. He can readjust his investment portfolio in the following way:
 
Equities
20%

Debt
60%
Alternative investments
10%
Cash
10%

Thus, tactical asset allocation will help Mr. A to make profit from the mispricing by switching from equities to bonds. For this reason, asset allocation is vital in investments because it determines returns for your investment portfolio. One should carefully analyze market and economic conditions while strategizing asset allocation so that it will provide profitable returns on investments. A financial services firm like Kotak Securities can help you to decide your allocations and minimizing risks by monitoring your equity through their share market software . You can strategize your investments by allocating your resources in a good mutual fund also.

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




No comments:

Post a Comment