Balancing risk and return with asset allocation

Investing is all about risk and return. Almost every investor aspires to get high return
with lowest possible risk. This, in actual sense, is not possible. The key, however, is to
strike the right balance between risk and reward. That is, investing in such a way which
effectively reduces the overall portfolio risk while maintaining the expected level of
returns. How do you do that? The answer is, through asset allocation. Asset allocation
is the process that seeks to balance risk and return in a disciplined manner. With the
right asset allocation, you can look to improve risk-adjusted returns. Here's how..

Asset allocation, in simplest terms, is deciding how to distribute your investment capital
among various types of asset classes, such as equity, debt, cash, gold, real estate, etc.
Most people confuse asset allocation with diversification. Diversification means
having a wide variety of investments within a portfolio, but that doesn't necessarily have
to involve different asset classes. Whereas asset allocation is the process of building a
portfolio of different asset classes with varying levels of correlation.

Correlation is a measure of the extent to which one asset class behaves in tandem
with another. Correlations between pairs of asset classes range from -1 to +1. A
correlation of positive one (+1) means that two assets will move together in lockstep or
in same direction (as one rises, the other also rises). A correlation of negative one (-1)
means that two assets will move in exact opposite directions (as one rises, the other
falls). A correlation of zero (0) means that two assets will move completely
independently from each other (uncorrelated to each other).

The idea is to choose assets that are negatively correlated to each other or are less
correlated (i.e. closer to zero). This will help ensure, that if any time, one asset does not
do well, the other will help provide some solace to the portfolio.

Historically, equity and debt asset classes have been negatively correlated. That is,
when equities go down, debt moves up, and vice-a-versa. The table below shows the
correlations of various asset classes over a period April 30, 2006 to December
31, 2012.

Table 1: Correlation of Different Asset Classes
Asset Class Equity Debt G-Sec Cash Gold (Rs.)
Equity N.A. - 0.26 - 0.48 - 0.62 -0.09
Debt - 0.26 N.A. 0.80 0.59 -0.05
G-Sec - 0.48 0.80 N.A. 0.66 -0.20
Cash - 0.62 0.59 0.66 N.A. -0.06
Gold -0.09 -0.05 -0.20 -0.06 N.A.

Correlations were arrived at, by taking daily rolling returns, for a period April 30, 2006 to
December 31, 2012; Indices used are: Equity - S&P BSE SENSEX, Debt - Crisil
Composite Bond Fund Index, G-Sec - I-Sec Composite Gilt Index, Cash - Crisil Liquid
Fund Index and Gold MCX Gold Index; Source: Accord Fintech.

Key observations from the above table:

1. Equity, as an asset class, has always been negatively correlated to asset classes:
Debt (- 0.26), G-sec (- 0.48), and Cash (- 0.62).

2. Generally, there is a view that gold has a negative correlation with equity. And it can be
seen from the above table that they have been negatively correlated (-0.09).

3. Gold, as an asset class, has always been negatively correlated to asset classes:
Debt (-0.05), G-sec (-0.20), and Cash (-0.06).

Asset classes over time
Asset classes move in cycles due to various factors such as economic conditions, industry
trends, investor sentiment, etc. The table below shows how various asset classes have
performed over a ten year period, on a calendar year basis, from 2003 to 2012.
Table 2: Calendar-Year Returns of Key Asset Classes


Asset Classes Absolute Returns
Calendar
Year
Indian
Equities
Global
Equities
Indian Govt.
Bonds
Gold ($)
Global
Commodities
2012 25.70% 13.18% 11.09% 7.14% -3.37%
2011 - 24.64% - 7.62% 6.55% 10.06% -8.26%
2010 17.43% 9.55% 6.04% 29.52% 17.44%
2009 81.03% 26.98% -2.99% 24.36% 23.46%
2008 - 52.45% - 42.08% 21.36% 5.77% -36.01%
2007 47.15% 7.09% 7.50% 30.98% 16.74%
2006 46.70% 17.95% 5.41% 23.15% -7.40%
2005 42.33% 7.56% 6.35% 17.92% 19.11%
2004 13.08% 12.84% -0.26% 5.54% 16.57%
2003 72.89% 30.81% 2.85% 19.37% 22.94%
We have highlighted calendar-year-wise best (blue) and worst (orange) returns across asset
classes. Indices used are: Indian Equities: S&P BSE Sensex, Global Equities: MSCI World
Index, Indian Govt. Bonds: I-Sec Composite Gilt Index, Gold: International prices in dollar,
Global Commodities: Commodity Research Bureau (CRB) index; Source: Bloomberg and
Accord Fintech.

As you can see from the above table, asset classes have performed quite differently each
calendar year. This explains the importance of building a portfolio of different asset classes. The
key is: Selecting asset classes that are not 'perfectly positively correlated' or have a correlation
of '+1'. This will help reduce the overall risk in your portfolio.
Putting together a portfolio of different asset classes
When putting together a portfolio of different asset classes, there are a number of parameters that
need to be looked upon. We describe below the main asset classes and some of their key characteristics.

Table 4: Asset Classes with Their Key Characteristics
Stay true to your allocation by regularly rebalancing
Asset allocation is not static. It changes with time, as the age of the investor increases and risk profile
changes. Also, whenever there is a change in the portfolio mix due to the returns generated by the
various asset classes, there is a requirement for re-balancing the portfolio to bring it back to the initial
allocation. If not rebalanced, the portfolio might take a hit on the returns generated over a period of
time. Put simply, re-balancing helps adhere to ones risk-return tolerance level. Its a good idea to re-
balance your portfolio at least once or on any important life event.

Summing up
Asset allocation is the single most important determinant of a portfolio performance. This is because a
portfolio's allocation among asset classes determines a large proportion of its return. Creating an asset
allocation plan based on your needs will not only help you balance risk and reward ratio, but will also
help you face any type of market with greater confidence.



Parameter
ASSET CLASSES
Equity

Debt

Cash Gold

Real Estate

Alternate
Assets

Representative
investments

Shares,
equity
mutual
funds

Bonds, debt
mutual funds

Savings
account,
Money
market
funds

Physical
gold, Gold
ETFs,
e-gold,
gold
mutual
funds

Physical
property,
real estate
mutual
funds, REITs,
realty stocks
Art, Antiques
and
Collectibles

Risk

High Low

Low

Medium Medium

High

Return

High Low

Low

Medium to
High (but
cyclical)
Medium to
High (but
cyclical)

High (but
Indian market
is volatile and
still needs to
mature)
Inflation protection

High Low Very low High High

High

Liquidity

High
(except for
ELSS funds)
High (except
for bonds
locked in for
minimum
period)

High

Medium to
High

Low

Low

Income

Yes, in case
of dividend
paying
stocks and
funds

Yes

Yes

Yes, in case
of dividend
paying gold
funds
Yes, if you
rent out your
property or
land

No

Capital appreciation Yes (but
cyclical)

Yes, in some
debt
instruments

No Yes (but
cyclical)

Yes (but
cyclical)

Yes (but
cyclical)
Lets take a look at an example of a brokers cost structure:
Take Janet Wall, a fictional broker that offers a full service to her clients. This is how her costs
break down for managing your portfolio:
1. She makes 1.5% annually of the value of the stocks that she manages.
2. She also gets a quarterly fee, which is $750 per account.
3. If she sells your stocks and makes you a lot of cash, she earns 2.5% of that profit. This
gives her more incentive to perform well and make you more money.
Here's what her year with your account might look like:
1. If your shares are worth $100,000, she makes $1,500 (1.5% x $100,000) annually to
manage it
2. Plus $3,000 (4 x $750) annually for her fee.
3. She later sells your stock holdings for $150,000, for a nice profit of $50,000. Janet gets a
cut of $1,250 (2.5% x $50,000 profit) more.
So Janet's total fee is: $1,500 + $3,000 + $1,250 = $5,750
Janets made a nice profit of 50 large, but youve got to give up $5,750 to her for her services.
Youre still walking away with a pretty penny.
Not all brokers or brokerage firms offer such a full service. You can also get a discount broker or
brokerage to simply conduct the trades for you at a set fee. They wont offer you any trading
advice, but youll also save a bunch of money on fees if you make these decisions yourself.
Next well take a look at discount brokerages, and give you some options of online brokerages
thatll get you started in the real world of investing when youre good and ready
Make sure you understand your brokers' compensation and be sure that the services
youre paying for are aligned with your interests.