Dynamic Asset Allocation

Dynamic Asset Allocation

Why is asset allocation important?

The principle of asset allocation is based on the experience of asset classes performing differently in different market and economic conditions.This is an important decision because this affects not only the long term investment return you can expect, but also the volatility of the portfolio over time.A proper asset allocation enables one to meet financial goals with higher certainty.

A study published by Brinson, Hood and Beebower in 1986, states that over 90% of the variability of a portfolio’s return is explained by asset allocation. What does that mean? It means your decision on whether to hold 20% or 40% of your portfolio in equity is much more influential on whether you get 10% or a 15% return on one of your equity funds or stocks.

There are different types of asset allocation strategies based on an individual’s risk tolerance level, his investment horizon and his goals.

Traditional Approach:

It starts with an asset class based on an investor’s expected rate of return and the average long-term performance of different asset classes.In this approach, the objective is to achieve the goal.

The assumption in this kind of approach is that each asset class would generate the desired rate of return annually and consistently since the time of financial planning. However, this rarely happens.

For e.g. a person following traditional approach and with a time horizon of 15 years, will invest in Equity asset class assuming 15% p.a. return. But what happens if Equity asset class underperforms in the 13th or 14th year? In that case, the goal in the 15th year won’t be met.

Static Asset Allocation Approach:

Under this approach, the asset allocation is determined by the time period left to achieve the goal. Then, this allocation is kept constant throughout the period of the goal.

The objective, here, is to first protect the downside by finding out the allocation to low risk asset class. Hence, the present value is calculated based on the Debt asset class return first. Then, the allocation is made to Equity asset class.

For e.g. Assuming 7% return from Debt asset class, for the goal which is 10 years away, the present value comes to 51%. The remaining 49% is then allocated to Equity asset class.

Dynamic Asset Allocation Strategy:

Dynamic Asset Allocation Strategy follows a different approach. During planning his finances, investor allocates more money towards riskier assets for a long-term goal; and then gradually shifts his money from riskier assets to low risk assets as the goal comes closer. Over time Dynamic Asset Allocation has shown to improve long term returns whilst reducing the severity of losses. Hence, this type of approach ensures fulfilment of goals with the highest possible certainty.

The primary objective is to protect the downside and also meet the goal.

Let us understand the importance of Dynamic asset allocation approach over the other types of asset allocation approaches, with an example.

For e.g. in 2007, a person had a goal of buying a house after 10 years.

Let us analyse which asset allocation approach brings him closest to fulfilling his goal.

Goal

Cost (Rs.) on      

01-Jan-2007

Cost (Rs.) on      

01-Jan-2017

Buying a house in 2017

60,00,000

155,62,455

Assumption: 15% return from Equity and 7% return from Debt.

Goal amount in 2007 (Rs.)

   60,00,000

Time (Years)

10

Inflation (%)

10

Goal amount in 2017 (Rs.)

   155,62,455

 

Ø In Traditional approach, allocation to Equity is 100% if the goal is more than 5 years away. The assumption over here is that Equity as an asset class gives the highest return in the long term. Hence in this case the default choice would be to invest in equity. The present value of lumpsum amount required on 01-Jan-2007 = 155,62,455/(1+15%)^10 = Rs. 38,46,801

Ø Staticasset allocation approach is based on the time period of the goal.

          Debt allocation: 1/(1+7%)^10 = 51%

          Equity allocation: 100% –51% = 49%

          Blended Growth rate: (49%* 15%)+(51%* 7%) = 11%

Hence, lumpsum amount required on 01-Jan-2007 = 155,62,455/(1+11%)^10 = Rs. 55,13,946

Ø In Dynamic asset allocation approach, the Equity-Debt allocation would be similar as above in the beginning year. However, the equity exposure is gradually reduced as we move closer towards the goal. Hence, lumpsum amount required on 01-Jan-2007 = 155,62,455/(1+11%)^10 = Rs. 55,13,946

Considering the Equity and Debt indices from 2007 till 2017, portfolio value each year would be as follows:

Wealthsecure

 As seen from this case study, Dynamic asset allocation approach gets you closest in fulfilling your goal.

The assumption of return from Equity asset class was 15% in this case study, however, it has actually delivered 7.5% return for the said period. Hence, the goal amount is not achieved after 10 years.

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