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The first is asset allocation, which is concerned with how an investment is spread across
different asset types and regions.
The second is fund selection, which is concerned with the choice of fund managers and
funds to represent each of the chosen asset classes and sectors.
Both of these considerations are important, although academic studies have consistently shown
that in the medium to long term, asset allocation usually has a much larger impact on the
variability of a portfolio's return.
To help in choosing a suitable asset allocation we have created a Risk Profiler that helps identify
your attitude to risk and therefore better identify a combination of investments to build a
portfolio.
With such a vast number of investment funds to choose from, spanning the full range of asset
classes and world markets it is easy to become confused when choosing which investments to
make. It is even more difficult to choose the right combination of investment to potentially meet
your investment goals.
Create your risk profile Measure your perceived level of risk for an investment (scale
of 1 to 10)
Asset Allocation Determining the right combination of assets the most important part
of the portfolio construction process.
Fine tune your portfolio Choose to invest in and/or review your existing portfolio to
fit in with the asset allocation most suitable to you, potentially reducing your risk and
increasing your returns.
Review your portfolio regularly Once you have constructed your portfolio, it is
important to continue to review your asset allocation on a regular basis. Investors failing
to do this, may find they become overweight in a particular asset class, potentially
increasing the overall risk of their portfolio.
Many investors have built collections of funds over their investing lifetime. As markets have
developed and investing styles come in and out of fashion, it is likely that the total portfolio may
be too heavily invested in a particular asset class (e.g. equities), region (e.g. Australia), sector
(e.g. technology) or even a particular share which is present in every fund but to varying degrees.
In other words, your combined portfolio may no longer meet your needs or aspirations.
Run through our Risk Profiler and see if your investment strategy still suits you
Risk Profiling
Investment risk profiling is an integral part of portfolio construction but is often overlooked by
DIY investors.
Modern risk profiling methods feed directly into suggested investment strategies to minimise
your investment risk
Historically investment risk profiling meant that if youre a middle of the road risk taker that
you shouldnt invest in speculative investments. This goes against the grain of DIY investing.
Its your money so dont limit the funds you can invest in
Risk profiling has progressed and suggested portfolios can incorporate your needs and
requirements to invest into the speculative when your overall profile is moderate risk taker.
Using our suggested risk profile investment strategies allows you to incorporate that new China
fund launch you want to take a punt on, but balance it out with other investments to fit in line
with your attitude to risk.
Our risk profiler gauges your attitude to risk for a particular investment. It asks a series of
questions and, based on your answers, provides an estimate of the level of risk you are prepared
to take with that area of your portfolio.
Our attitude to risk scale ranges from 1 (Very Cautious) to 10 (Ultra Speculative). Each person is
different and everyone has a different approach and perspective on the level of risk they are
prepared to take with a specific investment.
How does this help you construct and manage your portfolio?
Our suggested asset allocation strategies allow you to structure your portfolio or compare your
existing asset allocation against the level of risk you are willing to take, ensuring you are
investing suitably for your needs. For instance, if your risk level suggests you are a 5 (Moderate),
but all your investments are currently invested in an Emerging Markets fund, level 8-9
(Speculative to Very Speculative) then this may require some form of adjustment.
Asset Allocation & Efficient Investment Portfolios
Investment Asset Allocation Getting the investment mix right
Investment decision-making has traditionally been centred on which funds to choose. However,
investment research has shown that, in most circumstances, the asset allocation is the critical
factor in determining investment performance over the long term.
Its the behaviour of the asset class as a whole that makes the difference
Asset allocation - getting the balance between different types of assets right is the cornerstone of
successful financial planning.
Investment research has shown that the asset allocation of your portfolio is by far the most
important factor in determining investment returns. In fact, the asset allocation decision can be
more important than the choice of individual funds themselves.
This makes sense because individual stocks within a particular asset class can be highly
correlated and will tend to move together. i.e. It is the behaviour of the asset class as a whole that
really makes the difference.
Managing your own portfolio is an emotional roller coaster
Its only natural that you feel a loss if you worked hard for your savings and then see your
investments fall in value. Many investors who have held an investment for a number of years
look beyond the potential growth of their investment, feeling that any fall in value they have
suffered is not a loss until they finally sell the investment.
On the flipside, many investors who have seen large rises in sectors in the markets feel they are
losing out and invest to follow the market, hoping not to miss out.
Using asset allocation strategies to invest in inversely correlated asset classes is a way of taking
away the emotional roller coaster associated with DIY investment and giving you a long term
track to run on.
Another way of looking at it, is giving yourself a track to run on for your overall
investment strategy, you can focus on the fun part which funds and shares to invest
into
It makes sense to diversify your investments and not "put all your eggs in one basket" - if you
have everything invested in equities and the market falls you would lose out.
By diversifying the investment portfolio you can reduce risk and still invest in
equities aiming for good long-term returns.
Since different asset classes behave in different ways, structuring your portfolio with a number of
asset classes is one way of reducing the roller coaster highs and lows of investment.
Cash is typically a very stable market value, but normally provides the lowest
return.
Overseas equities add currency risk and are often even more volatile, but
give the opportunity of investing in different markets.
At a simplified level, diversification can be as simple as investing some in bonds as well as some
in equities, this would help you compensate for the loss - when equities fall, since bonds
typically rise as investment managers and investors look for less volatile investments to sit out a
fall in the market.
Efficient frontiers - efficient portfolio diversification
For a particular investment portfolio, it is possible to illustrate the potential return and the risk
(its volatility). As you might expect, different portfolios will give different risk-return results.
If you calculate the returns achieved using the same amount of risk, you would find some
portfolios would give a better investment return than others.
Transcript
3. It deals with two major decisions :-(a) Determining the objectives of the
portfolio.(b) selection of securities to be included in the portfolio.
5. Income needsa) Need for current income.b) Need for constant income.
Liquidity Safety of the principal Time horizon Tax consideration
temperament
7. Objectives and asset mix Growth in income and asset mix Capital
appreciation and asset mix Safety of principal and asset mix
8. Tradition approach has some basic assumption like the investor prefers
larger to smaller return from securities which requires taking risk. The risk
are namely interest rate risk, purchasing power risk ,financial risk and market
risk. The ability to achieve higher return is dependent upon his/her ability to
judge risk and his ability to take specific risk.
9. Selection of Top quality bonds can industries minimise financial risk while
stocks provide better inflation protection. Selection of company in industry
Depending on the preference and needs of investor appropriate combination
is selected. Determining the size of participation
10. Harry Markowitz put forward this model in 1952. It assists in the
selection of the most efficient by analysing various possible portfolios of the
given securities. By choosing securities that do not move exactly together,
the HM model shows investors how to reduce their risk.
12. To choose the best portfolio from a number of possible portfolios, each
with different return and risk, two separate decisions are to be made:1.
Determination of a set of efficient portfolios.2. Selection of the best portfolio
out of the efficient set.
13. A portfolio that gives maximum return for a given risk, or minimum risk
for given return is an efficient portfolio. Thus, portfolios are selected as
follows:(a) From the portfolios that have the same return, the investor
willprefer the portfolio with lower risk, and(b) From the portfolios that have
the same risk level, an investorwill prefer the portfolio with higher rate of
return.
14. The shaded area PVWP includes all the possible securities an investor
can invest in. The efficient portfolios are the ones that lie on the boundary of
PQVW. The boundary PQVW is called the Efficient Frontier.
15. Figure in right shows the risk-return indifference curve for the
investors. Each curve to the left represents higher utility or satisfaction.
16. The investors optimal portfolio is found at the point of tangency of the
efficient frontier with the indifference curve. R is the point where the
efficient frontier is tangent to indifference curve C3, and is also an efficient
portfolio.
17. All portfolios so far have been evaluated in terms of risky securities
only, and it is possible to include risk-free securities in a portfolio as well. A
portfolio with risk-free securities will enable an investor to achieve a higher
level of satisfaction. This has been explained further.
20. The portion from IRF to P, is investment in risk-free assets and is called
Lending Portfolio. In this portion, the investor will lend a portion at risk-free
rate. The portion beyond P is called Borrowing Portfolio, where the investor
borrows some funds at risk- free rate to buy more of portfolio P.
The portfolio giving the highest return for a particular level of risk is the most efficient - it gives
the most return possible for a defined level of risk taken.
Regardless of what level of investment risk you are willing to take, constructing and diversifying
your portfolio correctly allows you to access the greatest potential returns for your overall level
of risk.
Investment time-frame
Investment goals
Our Portfolio Planner makes sense of these factors by showing the risk-return profiles
personalised to you, to help you find the most appropriate asset-allocation to you.
The main goal of a conservative portfolio is to protect its value. The allocation shown above
would yield current income from the bonds, and would also provide some long-term capital
growth potential from the investment in high-quality equities.
A moderately aggressive portfolio satisfies an average risk tolerance, attracting those willing to
accept more risk in their portfolios in order to achieve a balance of capital growth and income.
Step 2: Achieving the Portfolio Designed in Step 1
Once you've determined the right asset allocation, you simply need to divide your capital
between the appropriate asset classes. On a basic level, this is not difficult: equities are equities,
and bonds are bonds.
But you can further break down the different asset classes into subclasses, which also have
different risks and potential returns. For example, an investor might divide the equity portion
between different sectors and market caps, and between domestic and foreign stock. The bond
portion might be allocated between those that are short term and long term, government versus
corporate debt and so forth.
There are several ways you can go about choosing the assets and securities to fulfill your asset
allocation strategy (remember to analyze the quality and potential of each investment you buy not all bonds and stocks are the same):
Stock Picking - Choose stocks that satisfy the level of risk you want to carry in the equity
portion of your portfolio - sector, market cap and stock type are factors to consider.
Analyze the companies using stock screeners to shortlist potential picks, than carry out
more in-depth analyses on each potential purchase to determine its opportunities and risks
going forward. This is the most work-intensive means of adding securities to your
portfolio, and requires you to regularly monitor price changes in your holdings and stay
current on company and industry news.
Bond Picking - When choosing bonds, there are several factors to consider including the
coupon, maturity, the bond type and rating, as well as the general interest rate
environment.
Mutual Funds - Mutual funds are available for a wide range of asset classes and allow
you to hold stocks and bonds that are professionally researched and picked by fund
managers. Of course, fund managers charge a fee for their services, which will detract
from your returns. Index funds present another choice; they tend to have lower fees
because they mirror an established index and are thus passively managed.
Exchange-Traded Funds (ETFs) - If you prefer not to invest with mutual funds, ETFs can
be a viable alternative. You can basically think of ETFs as mutual funds that trade like
stocks. ETFs are similar to mutual funds in that they represent a large basket of stocks usually grouped by sector, capitalization, country and the like - except that they are not
actively managed, but instead track a chosen index or other basket of stocks. Because
they are passively managed, ETFs offer cost savings over mutual funds while providing
diversification. ETFs also cover a wide range of asset classes and can be a useful tool for
rounding out your portfolio.
underweighted securities you will buy with the proceeds from selling the overweighted
securities. To choose your securities, use the approaches discussed in Step 2.
When selling assets to rebalance your portfolio, take a moment to consider the tax implications
of readjusting your portfolio. Perhaps your investment in growth stocks has appreciated strongly
over the past year, but if you were to sell all of your equity positions to rebalance your portfolio,
you may incur significant capital gains taxes. In this case, it might be more beneficial to simply
not contribute any new funds to that asset class in the future while continuing to contribute to
other asset classes. This will reduce your growth stocks' weighting in your portfolio over time
without incurring capital gains taxes.
At the same time, always consider the outlook of your securities. If you suspect that those same
overweighted growth stocks are ominously ready to fall, you may want to sell in spite of the tax
implications. Analyst opinions and research reports can be useful tools to help gauge the outlook
for your holdings. And tax-loss selling is a strategy you can apply to reduce tax implications.
Remember the Importance of Diversification.
Throughout the entire portfolio construction process, it is vital that you remember to maintain
your diversification above all else. It is not enough simply to own securities from each asset
class; you must also diversify within each class. Ensure that your holdings within a given asset
class are spread across an array of subclasses and industry sectors.
As we mentioned, investors can achieve excellent diversification by using mutual funds and
ETFs. These investment vehicles allow individual investors to obtain the economies of scale that
large fund managers enjoy, which the average person would not be able to produce with a small
amount of money.
The Bottom Line
Overall, a well-diversified portfolio is your best bet for consistent long-term growth of your
investments. It protects your assets from the risks of large declines and structural changes in the
economy over time. Monitor the diversification of your portfolio, making adjustments when
necessary, and you will greatly increase your chances of long-term financial success.
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