52 | F| NANC| AL PLANN| NG [ OUPNAL | [ULY - SLPTLM8LP 2007

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[ULY - SLPTLM8LP 2007 | F| NANC| AL PLANN| NG [ OUPNAL | 53
I
nvestors are well aware that the
chances oI meeting their long-term
investment goals are maximized not
by chasing the latest market theme or the
hot manager quarter by quarter, but rather
by deIining and sticking to appropriate
strategies over an extended period. Such
strategies can position a portIolio to
beneIit Irom the long-term Iorces in the
market, enabling investors to beneIit Irom
diIIerent risk-return trade-oIIs as they seek
higher returns than cash.
The Ioundation oI such an approach
lies in Asset Allocation`. Asset allocation
is the process oI combining diIIerent asset
classes (in varying proportions) in a
portIolio in the perimeter oI one`s goals.
The asset allocation decision is an
important Iactor in determining the return
and the risk oI an investment portIolio.
Every asset class has diIIerent
characteristics and its response to market
changes may vary. This makes due
diligence indispensable while choosing
assets, allocating monetary resources to
each asset and determining the time Ior
which each asset is to be held Ior the
portIolio. An investor`s Iinancial needs,
the length oI his investment horizon, and
his appetite Ior risk inIluence the asset
allocation decision. A wise and well
researched asset allocation decision
reduces the risk exposure oI the portIolio
while maximising returns.
The combination oI asset classes in a
portIolio is the single most important
Iactor in explaining the variability oI
returns oI an investment portIolio.
Research demonstrates that asset
allocation decisions account Ior 91.5
percent oI a portIolio`s perIormance as
demonstrated in Chart 1
Reducing Risk Through
DiversiIication
The most important advantage oI asset
allocation is the reduction oI risk in a
portIolio through diversiIication. As the
number oI asset classes in a portIolio
increases, the total risk oI the portIolio
decreases. Through diversiIication, the
eIIect oI any individual security or asset
class on the perIormance oI the portIolio
can be limited.
A portIolio should be diversiIied at two
levels: between asset categories and within
asset categories. So in addition to allocating
investments among stocks, bonds, cash
equivalents, and possibly other asset
categories, investments should be spread
within each asset category. The key is to
identiIy investments in segments oI each
asset category that may perIorm diIIerently
under diIIerent market conditions.
Rebalancing The PortIolio
The asset allocation decision is not a one-
time decisionit is a process. As an
investor`s time horizon, needs and risk
tolerance capacity undergo changes, the
composition oI the portIolio also needs to
change. Asset classes too grow at diIIerent
rates oI return, and react diIIerently to
market changes; it is thereIore necessary
to periodically rebalance a portIolio to
maintain a target asset mix.
For example, in a particular portIolio,
investments should represent 50 percent
oI the portIolio. But aIter a stock market
increase, stock investments represent 75
percent oI the portIolio. Now in order to
reinstate the original asset allocation mix,
either some oI the stock investments
should be sold or additional investments
Irom an under-weighted asset category
should be purchased.
While rebalancing, one also needs to
review the investments within each asset
allocation category. II any oI these
investments are out oI alignment with the
investment goals, changes should be made
to bring them back to their original
allocation within the asset category.
Building Optimal PortIolios
In 1952, Harry Markowitz was the Iirst to
quantiIy the link that exists between the
risk and return oI a portIolio, when he
introduced the Modern PortIolio Theory.
Markowitz`s pioneering approach is based
on a simple principlemaximising the
investor`s objectives as a Iunction oI the
risks being run, with the latter being
measured by the volatility oI the assets.
The EIIicient Frontier is a series oI
points that models the range oI possible
portIolios, each representing the highest
returning combination oI investments Ior
a speciIied level oI risk. Each point along
the Frontier represents a combination oI
asset classes that can, in theory, provide
the highest level oI return Ior an individual
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Amer|con xpress, lnd|o
Source. A lanamark stuay, 'Determinants
of Portfolio Performance`, by Brinson,
Hooa ana Beebower.
Chart 1
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Chart 2
investor `s speciIic risk tolerance.
Similarly, it also depicts the lowest level
oI risk to help achieve a desired return
target (Chart 2).
7LEVTIVEXMS helps you Iind the best
possible proportion oI securities to use,
in a portIolio that can also contain cash.
The deIinition oI the Sharpe Ratio is:
S(x) ( r
x
- R
I
) / StdDev(x)
where
x is some investment
r
x
is the average annual rate oI return
oI x
R
I
is the best available rate oI return
oI a 'risk-Iree security (i.e. cash)
StdDev(x) is the standard deviation oI r
x
The Sharpe ratio is used to characterize
how well the return oI an asset
compensates the investor Ior the risk
taken. When comparing two assets each
with the expected return E|R| against the
same benchmark with return R
f
, the asset
with the higher Sharpe ratio gives more
return Ior the same risk. Investors are oIten
advised to pick investments with higher
Sharpe ratios.
The Sharpe Ratio is a direct measure
oI reward-to-risk. To see how it helps you
in creating a portIolio, consider the
diagram oI the EIIicient Frontier again,
this time with cash drawn in.
II you take some investment like 'x
and combine it with cash, the resulting
portIolio will lie somewhere along the
straight line joining cash with x. The result
will be the portIolio with the greatest
possible rate oI return
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(CAPM) is an economic model Ior valuing
stocks, securities, derivatives and/or assets
by relating risk and expected return.
CAPM is based on the idea that investors
demand additional expected return called
the risk premium iI they are asked to
accept additional risk. It helps us to
calculate the expected investment risk and
return.
CAPM model says that the expected
return that investors would demand is
equal to the rate on a risk-Iree security plus
risk premium. II the expected return does
not meet the required return, the investors
will reIuse to invest and the investment
should not be undertaken.
CAPM can be calculated in the
Iollowing way
Expected Security return Riskless
return Beta * (Expected market risk
premium)
Beta is the overall risk in investing in large
market like, the New York Stock exchange.
Each company has a Beta. A company`s
Beta is that company`s risk compared to
the Beta (risk) oI the overall market. II the
company has Beta oI 3.0 then it is said to
be three times more risky than the overall
market. Beta measures the volatility oI the
security, relative to asset class.
Rewards oI Asset Allocation
and Rebalancing
Asset allocation and rebalancing play
important roles in achieving and
maintaining diversiIied and disciplined
investment portIolios. These relatively
straightIorward investment strategies can
provide investors with a number oI
potential beneIits.
A diversiIied portIolio can experience
reduced investment risk because the
growth opportunity is not limited to the
perIormance oI a security, but is open to
opportunities presented by a collection oI
securities. The perIormance oI one laggard
investment will not aIIect the entire
portIolio.
Investing in a selection oI securities
spread across diIIerent asset classes builds
a portIolio that may help reduce volatility
in turbulent times. A well diversiIied
portIolio can provide investors with the
opportunity Ior growth with less portIolio
volatility.
It is nearly impossible to time the
perIormance cycles oI diIIerent
investment categories. Establishing an
asset allocation strategy and rebalancing
regularly to preserve that strategy will
introduce more discipline into an
investment plan.
Conclusion
PortIolio asset allocation accounts Ior the
majority oI variation in investment returns,
thereIore research eIIorts should be Iocused
on monitoring and adjusting asset allocation
rather than market timing or security
selection. EIIective tactical asset allocation
process adds value in the longer-term by
applying temporary tilts and changes oI
emphasis to the portIolio`s strategic asset
array within agreed boundaries.