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Beat risks with smart strategies: Asset allocation is key

Published on Mon, Jun 26, 2006 at 11:07 | Source : Moneycontrol.com

Updated at Mon, Sep 18, 2006 at 15:42

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With unavailability of data related to India, let me straight away start with hard facts from where I would like to lead to the potential keys to successful investing.

Based on research by US research group DALBAR, the average US investor's return has been significantly lower than what the market indices have actually delivered. Over the past two decades, the average US equity investor earned only 2.6% per annum compared to the inflation rate of 3.1%. This occurred even when the market (represented by the S&P 500 Index) delivered 12.2% per annum over the same period.

The key to successful investing is to first spend time on learning and validating how you naturally behave around money which is unique behaviour for each one of us and then keeping your goals in the centre, replace emotion driven investing methods with a systematic and logical investment framework

According to Ibbotson Associates, 40% of the return difference from one fund to another was explained by asset allocation. For example, if one portfolio returns 5% more than the other, then on average, about 2% (40% of 5%) is attributable to the different asset allocations. The remaining 3% (60% of 5%) is explained by other factors such as asset class timing, security selection (that is quality, value, diversification), and fees.

Asset allocation is thus based on diversification of various risks. What are they? The following Risk Ladder provides a useful classification of risk into five levels:

INTERNATIONAL

RISK

COUNTRY

RISK

ASSET CLASS

RISK

INDUSTRY

RISK

INVESTMENT

RISK

These risks can be diversified in the following ways:

a) Balance portfolio over shares, bonds, property and cash

b) Look for themes, diversify across industries or sectors

c) Buy Overseas

Let us address the issue of what kind of risks can be reduced by diversification:

Investment (Company) Risk: This comprises factors that may affect the returns of a specific investment entity such as a strike, a natural discovery, loss of key personnel, and so on.
Industry Risk: This affects some groups of investment entities, but not all for example, changes in tariff protection, new safety standards, new technology and so on.
Asset Class Risk: This comprises factors affecting all bonds, stocks, and cash investments for example, introduction of a tax or regulation affecting a particular asset class.
Country (Economy) Risk: This comprises factors affecting all asset classes in an economy such as level of economic confidence and consumer demand, political stability and so on.
International Risk: International Risk comprises all factors that affect investment entities globally, such as world recession or financial system collapse.

How to go about investing

There are three broad ways to invest:

Direct Transactions whereby the investor purchases shares or property directly. This method has its own advantages and disadvantages. The advantages are that the investor has control over his own investments. The disadvantage here is that research capabilities of an individual may not be of a very high level and he may end up taking uninformed decisions.

Mutual Funds: The mutual fund was invented to overcome the disadvantages of direct investments through professional management and diversification. Advantages here are, unlike direct investments they offer diversification and full time professional management. Disadvantages here include not being able to provide customized portfolio for each individual based on their goal and time horizon so asset allocation strategies are not built in. Also manager selection may not be monitored.

Financial Planning and wealth managment Service:: To overcome the disadvantages of both of above, financial planning and wealth management services can help in customizing investment plan as per individual goals with proper asset allocation which can lower risk, optimise returns with prudent manager selection and monitoring.

The author, Zankhana Shah, is a Certified Financial Planner. She can be reached at zankhana.shah@moneycontrol.com .