Asset allocation for risk adjusted returns

While everyone invests and aspires to generate higher returns though investing, most people fail to realise this goal due to the improper allocation. Many of us know the possibilities of each of asset classes like equity, debt, real estate, etc. could do to a portfolio. What most fail at the allocation that needs to be done to optimise the risk and thus achieve a better return.

In pursuit of higher returns, one may end up taking significant higher risk than they could tolerate. This could happen by having exposure to a single or predominantly to an asset or an investment. If that asset or investment were to not live up to the expectations, then there’s a huge possibility of missing the goal within the defined timelines. Or if the asset or investment experiences a downturn, it could upset the whole portfolio and so the goal.

This is the reason we must diversify the investments across various asset classes so that risk is distributed while also maximising the possibilities of a risk. Even within an asset class one could explore spreading the investment across sub-classes or avenues like, if the investment is in direct equity, one could create a portfolio of multiple stocks so that the exposure of the capital is not risked on one stock. However, the important aspect of this is the allocation size and to the above example, position sizing.

This is where the asset allocation strategies come to fore. An asset allocation strategy is where the investor or fund manager allocates investment capital across various asset classes to achieve diversification and risk adjusted returns. One has to also remember that the best diversification is achieved through a creating portfolio of assets which are either not correlated or least correlated. That provides for the portfolio to react contrary or dissimilar to the overall market as it remains less sensitive to the overall investing conditions.

By adding a fixed income investment to the portfolio, the vagaries of equity market are contained or offset. This allows the portfolio to remain stable in times of turmoil than a fully invested equity portfolio. Also, the amount of cash to be retained in a portfolio could be decided upon the active strategy that one employs. If the investor believes that additional investments to equity is done at corrections, then availability of capital is good and so the cash component. However, cash is a depreciating asset (inflation risk) and so the amount of cash or the form of cash equivalent should be well designed.

There are multiple asset allocation strategies based on how it is designed. For instance, in NPS, National Pension Scheme, the allocation to equity in a life-stage strategy shifts or reduces over time or as the subscriber ages. This age-based allocation suits for those who believe their risk should be reduced as the reach towards retirement.

For some a strategic allocation might suit where the allocation involves a pre-fixed weightage to each asset chosen. This remains constant during the entire period of investment. The return expectation is then a simple weighted average return of each asset. A variation could be done to this strategy by tweaking the weightage or allocation depending or expecting on market conditions. This is done for a short period i.e., opportunist times.

In a bearish market, a risk-taking investor could increase the weight towards equity allocation and then reduce during a bull phase or when the investor considers too much of froth in the market. This kind of addresses the need for cash in the portfolio to take opportunities while also creating cash when those opportunities slim.

Whereas a dynamic asset allocation strategy involves an active participation of the investor or fund manager to shift allocation among the assets to capture the business or economic cycles experienced. The above exercise is done on a repetitive basis to achieve better risk adjusted returns. Then there’s an integrated asset allocation strategy where the risk tolerance of the investor is considered on the weightage provided to the allocation.

Whatever could be the method, asset allocation thus strives to achieve better returns while reducing the risk.

(The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at [email protected])