Modern Portfolio Theory contains within it a very simple yet very powerful concept, known as the Efficient Frontier.
Wikipedia states it succinctly, as:
"A combination of assets, i.e. a portfolio, is referred to as "efficient" if it has the best possible expected level of return for its level of risk (usually proxied by the standard deviation of the portfolio's return).
Every possible combination of risky assets, without including the risk-free asset, can be plotted in Risk -Expected Return space, and the collection of all such possible portfolios defines a region in this space. The upward-sloped (positively-sloped) part of the left boundary of this region is called the "efficient frontier". The efficient frontier is then the portion of the opportunity set that offers the highest expected return for a given level of risk."
The simpler explanation, for those not statistically inclined, is this:
Consider the universe of investments, or assets.
Each asset carries with it a certain level of risk and expected return.
For example, within the debt / fixed income space, a Government bond would be low to no risk, and hence low return, compared to say a bank FD, which is not completely secured (bank FDs are secured to the extent of Rs. 1 lakh by the Deposit Insurance and Credit Guarantee Corporation - DICGC), and hence slightly higher risk, with slightly higher return, compared to say a completely unsecured corporate bond, which is significantly higher risk and therefore has to offer commensurately higher return.
Not all assets will reward higher risk with equally high return. Those that do not offer enough expected return for a high level of risk are considered ‘inefficient’.
Those that do offer the highest expected return for a given level of risk form a sub-universe called the Efficient Frontier in Modern Portfolio Theory.
These are the most rewarding investments to make, for their level of risk.
How does this affect you?
Consider the case of our favourite fictional character, Mr. Shah.
Mr. Shah is about 40 years old, has 2 kids, and has been making investments for the last 15 years.
His portfolio is fairly well diversified. It comprises equity and debt mutual funds, stocks, some corporate deposits, bank deposits, his EPF and PPF, tax saving infrastructure bonds, and he holds cash in his bank accounts and has liquid funds, for use in case of emergencies.
When he makes investments, it is largely the result of advice he receives from his financial planner, in line with his life goals such as his retirement, children’s educations, the house purchase that is planned and others.
But what goes into the research and planning behind his financial planner’s unbiased advice?
Asset allocation is essentially an investment strategy that balances your portfolio’s risk and reward, keeping in mind your risk tolerance and appetite, your life goals i.e. your financial requirements, and your investment time horizon.
The importance of asset allocation lies in the overall risk-return performance of your portfolio.
Both asset allocation and rebalancing your portfolio when required, play an important part in having a well diversified and a disciplined portfolio. The number of benefits provided by these 2 relatively straightforward investment strategies is immense and Mr. Shah’s Financial Planner knows this.
- Lower investment risk
A diversified portfolio will be exposed to lower investment risk, because the growth prospects are not limited to one risky security, but rather a basket of both risky and non-risky securities, across equity, debt, gold and real estate.
- Low dependence on a single asset for returns within an asset class
Not all assets within a single asset class e.g. equity, perform well at the same time. This is what makes it important to choose different stocks and different categories of mutual funds, e.g. large cap, value style and so forth, and allocate funds efficiently even within the same category.
- Protection from Market Turbulence
Anybody who has lived and invested though the sub-prime mortgage crisis knows that when equity caused the ground to fall out from under our feet, debt and gold kept investors’ heads above water. For those who had pure equity portfolios, it was a mistake they will likely never make again. A well diversified i.e. a well allocated portfolio will afford you protection and offer you growth even during times of volatility.
- Freedom from timing the market
Consider timing a single asset class’s market. Those investors who try to actively time the equity markets can testify to its volatility. Now imagine timing the performance and market movement across different asset classes. Investing without stress is not hard to achieve, if you remove timing the market, or markets, and implement a disciplined strategy.
Asset Allocation is also different for investors with different goal time horizons.
For somebody with a short term investment horizon i.e. 3 - 5 years or less, it is advisable to allocate more funds towards fixed income, and allocate fewer funds in your portfolio to riskier assets such as gold or equity.
For a medium term investment horizon i.e. more than 5 years, your allocation to riskier asset classes can increase, to take advantage of the higher risk-reward ratio that these classes offer. However, maintain a healthy allocation to fixed income with low risk to balance your portfolio as your investment horizon reduces.
For a longer term investment horizon i.e. closer to 10 years, you can allocate a higher proportion of your funds to riskier asset classes, to take advantage of the power of compounding in your longer time horizon. Maintain some exposure, if not too high, to fixed income and gold to provide safe, fixed returns and to hedge against the risks of equity and inflation.
These horizons might seem conservative, but consider this. In 2008, we fell from 21,000 to 8,000 on the Sensex. We are now in September 2012 and have still not recovered. Conservative is good.
At PersonalFN, we believe so strongly in the importance of asset allocation and rebalancing, that we have asked our founder, Ajit Dayal, to be the guest speaker at our first Websummit - "The Ideal Asset Allocation In Current Market Conditions". You can Register Here to view the websummit.
And remember, keep your asset allocation in mind and rebalance your portfolio as per your financial plan, and 90% of the job of achieving your life goals is done.