The Importance of Asset Allocation and Security Selection

Asset Allocation and Security Selection –

Diversifying is the key to successful investing. Allocating investments across different asset classes helps to minimize risks and increase gains.

If you think of it in terms of dividing your investment portfolio across numerous asset classes, you have just used the asset allocation strategy.

Dividing investment portfolio across asset classes such as bonds, stocks and money market securities can help in multiplying profits and using the right asset mix can help you to maintain it.

Asset Allocation: Putting Eggs In More than One Basket

Within asset allocation, there are three basic options namely bonds, stocks, and cash. Inside these classes come the sub-classes or further categories.

Asset Allocation: Many Options, Rich Dividends

For instance, stocks are divided into large, medium and small cap representing the shares issued by companies with varying market capitalization. On the other hand, if you are thinking in terms of foreign companies and assets issued by them on the listed foreign exchange, these are international securities.

While stocks help you to diversify within your own country, international securities enable investors to expand beyond their country. The downside? There is always a risk a country may fail to honor its financial commitments.

If a risk is high, rewards are higher still. This holds true for trading securities in emerging markets which represents those that are issued from financial markets of developing economies.

But for every reward, the risk does not lessen. Factors like less liquidity, high country risk and the possibility of political insecurity plague markets trading in such securities.

If security is what you seek, asset allocation should be geared towards fixed income securities. These are fixed income asset class comprising debt securities which yield fixed interest and return of principal.

Less volatile than equities because of the steady and stable income they field, fixed income securities only lead to financial instability when there is a risk of default. Examples of fixed income securities include government bonds.

Money market securities are debt securities with a maturity of less than one year. They may score lower on profits, but they are high on liquidity. These type of bills also include the Tor treasury bills.

Real estate investment trusts are yet another asset class. They differ from equities in that the underlying asset revolves around a pool of properties and/or mortgages rather than part ownership of a company.

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Asset Allocation: The Golden Rule

Maximizing gains and minimizing risk is the main rule here. Asset allocation should work to lower risk and increase returns. Risks and potentials of some popular asset classes are assessed below:

While equities have the highest return, they also carry maximum risks. T-Bills have the lowest risk as they are backed by governments, but also provide low potential returns.

High-risk tolerance and longer time horizon to gain on losses are what predict which side of the risk-return trade-off you will be on. Always remember that potential returns rise with increasing risk.

Diversification is the way out. Why? Simply because differing asset classes have different risks and market fluctuations. Efficient asset allocation strategy serves as a safeguard against see-sawing of values seen with a single class of securities.

To be a world class investor, you have to give up old school investment and turn to diversification. This involves maintaining an even keel whereby part of your portfolio may be in choppy waters given high volatility, but another component is steady as can be.

Due to this reason, asset allocation and consequent diversification is the key to lasting success in the markets.

Each asset class has varying levels of return and risk. How do you go about getting the most balanced portfolio? Factors to consider are as follows:

• Risk tolerance: Capacity to bear losses and tolerate risks
• Investment objectives: Growth versus stability or quick returns versus steady returns
• Time horizon: This can vary from long to medium and short
• Available capital: You can only drive the car based on how much fuel you have. Available capital serves as an engine for driving growth through various investment vehicles.

High risk, high returns options: For this purpose, investors must have a long time horizon and large sums to invest

Low risk, low return allocations: These are perfect for investors dealing within a shorter time period and smaller sums

Portfolios are ranked on the basis of how conservative or aggressive they are an as high risk or low risk.

Preserving the Capital: Conservative Portfolio

This type of portfolio allocates a massive percentage of the total portfolio to low-risk securities. This includes T-bills, government bonds and fixed income securities.

This type of portfolio is also called “capital preservation portfolios.” The goal is not to buck the trend, but to go along with it.

Playing with Risk: Moderately Conservative Portfolio

With this type of portfolio, capital preservation is coupled with a larger appetite for risk, so securities with high dividends and coupon payments are definitely on the table. A strategy associated with this portfolio is “current income”

Balancing the Risk: Moderately Aggressive Portfolio

This is referred to as “balanced portfolios” since an equal amount of money is invested in equities and fixed income securities to get the best of income and growth. This carries a higher level of risk and is for investors with a longer time horizon.

Capitalizing on Risk: Aggressive Portfolio

This refers to a portfolio where investment in equities is higher than fixed income. Investors with a very long time horizon opt for this approach as a meaningful goal is long-term capital growth. This is why an aggressive portfolio follows a “capital growth strategy”.

Encashing on Risk: Very Aggressive Portfolio

This comprises entirely of equities with very little investment in fixed income securities or cash equivalents. Aggressive capital growth over a long-term horizon is the goal here and risk is massive.

Choosing the right asset allocation strategy depends on future needs for capital and the category to which an investor belongs. Amount of cash equivalents depend upon the extent of liquidity required.

There are several different asset allocation strategies and their foals depending upon the time frame of the investor, goals, capital and risk tolerance. Asset allocation strategies include constant weighing, systemic asset allocation, strategic vs tactical asset allocation.

Once the asset allocation strategy is selected reviews are needed so a value of various assets changes. Asset allocation models should be accompanied by reverencing or selling portions of the portfolio that rose significantly and through these, purchase additional units of assets that have declined somewhat or increased at a lesser rate. Asset allocation models maximize profits and lower risk.

Different Asset Allocation Strategies: The Right Asset Mix

An appropriate asset mix is a matter of assessing overall risk and return. Depending upon the goals and appetite for risk, a certain strategy may be up for grabs.

Asset Allocation Strategy: Buy and Hold Strategy

This method of asset allocation sticks to a base policy mix which is a combination of assets in a proportion associated with expected rates of return. For example, if stocks returned 5% per year and bonds returned 10%, a 50% mix of these would yield 7.5% returns per annum.

Constant-Weighting Asset Allocation Strategy: Re-balancing the Portfolio

A constant weighting approach to asset allocation involves constant re-balancing of the portfolio. This is completely against a buy and holds strategy characteristic of asset allocation strategy.

With this approach, asset values that are declining are purchased more while asset values that are rising are sold more. A portfolio should be re-balanced to the original mix when the given asset class moves 5% from the original values.

Tactical Asset Allocation Strategy: Deviations from the Mix

This asset allocation strategy can become rigid over the long term. Short term tactical deviations are needed to capitalize on investment and growth opportunities. This is a moderately active strategy so the portfolio may be adjusted to the short term and then re-balanced to the long-term asset position.

Dynamic Asset Allocation Strategy: Adjusting the Mix

In this active asset allocation strategy, investors adjust the mix depending upon the state of the market and the economy. Selling assets that are declining and purchasing assets that are increasing make this the exact opposite of the constant weighting strategy.

In this asset allocation strategy, whether the market is bull or bear determines your strategy rather than being caught in a herd or group mentality.

Insured Asset Allocation Strategy: Adjusting the Portfolio

As long as the portfolio receives a return above its base, active management is resorted to. There is a base value below which the portfolio must not fall. In case it does, the base value is fixed by investing in risk-free assets.

Insured asset allocation strategy is a wonderful strategy for getting fixed returns…it is like an economic insurance policy.

Integrated Asset Allocation Strategy: Mixing All Strategies

This type of asset allocation strategy includes aspects of all strategies with the added advantage of factoring in future market returns. Economic expectations and risk are crucial determinants of strategy here. Dynamic or constant weighted allocation are the two most frequently blended strategies under this approach.

Avoiding Frauds: Lessons for Investors

In one of the largest Ponzi schemes in the history of the finance world, Bernie Madoff defrauded his clients to the tune of USD 50 billion. Closer home, investors faced the music when Harshad Mehta made off with their hard earned money.

Money management industry has always been plagued by financial frauds. So, how can you ensure you do not take the bait? If getting hooked on to too good to be true returns is a habit with you, read on to learn all about how to avoid investment frauds.

How to Avoid Falling Prey to Scammers

Smooth investment returns could be a potential warning signal. It should definitely set the alarm bells ringing if the markets are volatile. Consider steady returns in periods of abnormally high fluctuations to be your wake up call.

Checking up on References

Another important investor tip to avoid getting defrauded is to engage in reference checks while entering into any business partnership. Due diligence and doing your homework help in passing the test and avoiding a fraud. Regulatory bodies frequently contain information about the investment manager as well. This can be a good place to start your research.

Utilize Outside Financial Firms

Many fraudsters operate as their own broker-dealers to avoid leaking important information to clients. Outside financial firms can serve as custodians of public interest within investment transactions. Clients can also verify the nature of asset levels and returns using the services of such firms.

Does the Investment Manager Put His Money Where His Mouth Is?

Proof of the pudding lies in eating in and a true test of investment managers is whether they can invest their money in the same strategies as clients.

This has numerous advantages including confidence in the investment strategy, keeping fund expenses low and alignment of manager and customer interests.

Consider Warren Buffet’s stupendous success in investing his own money along with that of others, if you want a success story. Michael Milking “milked” people out of their asset allocation funds and Bernie Madoff made off with their money. But you can ensure that you are not their next victim by following these simple strategies.

Conclusion

Money management is all about efficient asset allocation. A risk is directly proportional to reward and asset allocation minimizes the risks and maximizes the rewards. Diversification is the key to financial success and so is investor alertness.

There’s no point in earning returns if you are going to lose them to a financial fraudster. As Warren Buffet has remarked, “ Opportunities come once in a while so when it rains gold, put out a bucket, not a thimble”. But in the face of a potential financial fraud, the very opposite holds true.

Be cautious about your investments and choice of investment managers as well. It is equally important to conduct background checks and tick off all the prerequisites before investing.

The correct choice can make the difference between profit and loss, win or lose, rewards or zero returns. So, make sure you dial the right number and do your research before choosing an investment manager because this counts the most.

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