Where are your profits coming from?
An explainer on asset allocation & steps to assist your selection
Founder of India’s largest broking app Zerodha’s founder Nithin Kamth admitted in a recent interview that not even 1% of the traders earn more than FD rates. This shocking revelation has prompted many to assess the returns on their portfolios, whether traders or investors. If you haven’t carried out a portfolio check and realized how much you actually gained or lost yet, we urge you to.
Even if you earned great returns in a few bets but your portfolio hasn’t grew much overall, you need a portfolio checkup!
What is asset allocation?
Asset allocation is a method used to spread your capital amongst diverse investment instruments in such a way, that the mix of your portfolio caters to your return requirements, taking into consideration your risk constraints.
The goal of an asset allocation strategy is to maximize your returns while minimizing risk.
How does it work?
Though the definition is self explanatory, let’s break down the benefits for a better understanding.
Diversification - the golden rule
A universal concept states that level of risk = level of returns. Riskier assets reward you with higher returns, though not all the time. A desire for higher returns leads us to underestimate the risk aspects of an asset. We are looking for maximum returns with respect to a certain level of risk.
This can be achieved if we possess a portfolio that consists of assets that ensures stable returns at all times. Such a mix can be obtained by diversification. Diversification, in investing terms, means combining assets of low correlation (assets that are least related to each other in performance) so that an average stable return can be earned during different economic scenarios. For example, having both, stocks and gold ensures stable returns because stocks do well in a good economy and gold prices surge during relatively tight economic conditions.
Theory of total returns to portfolio
A prudent investor is subject to the bias of mental accounting which is thinking that a loss making investment in one stock better be offset by a profit in a similar stock or asset class. But your overall portfolio doesn’t care about that.
Bad decisions about one investment cannot be isolated, they affect the entire portfolio, according to its relative size to the entire portfolio. Losing 10% on 90% of your entire portfolio is worse than losing 50% on just 10% of your portfolio. Our aim is to allocate the right amount of capital to each asset, which ensures a robust total portfolio.
In fact, professional investment managers are required to consider and communicate the effects of an investment action on a client’s total portfolio before making a decision to invest, as per ethical standards.
The Right Allocation
Now that you know the theory of total portfolio and why it is important to have a good strategy, let us tell you how you can begin your quest for an optimal combination of assets.
Establish Your Goals, Risk and Time Horizon
One size doesn’t fit all. Everyone has different goals, risks, time horizons and personalities. Just copying a portfolio pattern would do you more harm than good.
Establishing a long term goal is the first step you need to take. A 25 year old who has just started investing can allocate some capital to risky investments like mid-cap and small-cap equities to grow their wealth. One can invest in risky assets if they are young because the volatility can be absorbed over time. But a retired person would rather invest in income generating bonds, since income, and not capital appreciation is their goal. It also offers a low risk structure. Risk constraints need to be considered before an investing decision. One shouldn’t invest in risky assets like futures and options if one doesn’t have the wealth and appetite to absorb potential losses. The following diagram can help identify suitable assets:
Types of Portfolios
It can be difficult to settle on the right mix of assets when there are innumerable options out there, and analyzing each one for pros and cons is a demanding job. To start with, stick to traditional assets - equity (can be ETFs, mutual funds, shares), debt instruments like bank deposits and cash. Here is a template you can use for reference, according to your appetite.
Once you have a stable corpus, you can consider venturing into diverse asset classes like real estate, precious metals and private equity.
Maintaining the Portfolio
We aren’t done, yet. Making good investments is just one part of the game. The next crucial step is to accurately measure and maintain the balance you established.
How would you rebalance your portfolio if you don’t understand the return characteristics in the first place? This brings up a crucial point that 70% of the investors neglect: measuring returns. Measuring your portfolio returns for each asset , preferably in a time weighted manner would tell you exactly where your profits are coming from. This will enhance your understanding of what’s working in the prevalent economic conditions.
Due to capital appreciation or depreciation in certain assets, your allocation structure may be out of proportion from the initial benchmark. A rebalance to the original composition would be ideal. However, if you expect certain asset classes to perform well in the near term, you can also consider short term investments in those to enhance your overall returns. Remember that these decisions should be guided by keeping in mind your risk limit or stop loss.
At last, remember that achieving a totally optimal portfolio is impossible, but getting better with each investment decision is what you can strive for.