A Simplistic Approach to Asset Allocation Strategy (Part 2)


As a continuation from M&W 9 th issue, we shall begin by asking you to answer the following 10 questions as candidly as you can in order to determine what kind of an investor you are. Quiz Table.

Kindly note that, there are no right or wrong answers here. The main aim of the exercise is to assess your risk profile. This profiling exercise entails a subjective psychological analysis of your risk tolerance (willingness); an objective analysis of your financial health and other financial constraints (ability); and a computation of a target investment return over a determine time horizon based on your financial objectives (need). Depending on you scores, you will now be able tell what kind of an investor you are and the appropriate asset allocation for you.

Efficient asset allocation portfolios are created through financial modeling. This process entails taking expected returns, standard deviations (risk) and correlations between the various asset classes and combining them together to arrive at a certain mix (the ideal percentage of equities, bonds and cash) that lie on or near to the efficient frontier. As you can see from the tables below

(Buy and Hold Strategy)

(Conservative)
(Moderate)
(Aggressive)
Equity Funds
30%
50%
70%
Bond Funds
40%
30%
20%
Cash(Money Market Funds)
30%
20%
10%

(Expected Return)

 
Historical Risk/Return Profile
Average
Standard Deviation
Return Forecast (%)
Bad Year
Normal Year
Good Year
12.2%
20.3%
5.7%
8.4%
3.7%
3.3%
-8.1
12.2
32.5
-2.7
5.7
14.1
0.4
3.7
7.0
Equity Funds
Bond Funds
Cash(Money Market Funds)

(Conservative Portfolio)
Asset Mix
Bad Year
Normal Year
Good Year
Equity Funds
30%
-2.4
3.66
9.75
Bond Funds
40%
-1.08
2.28
5.64
Cash(Money Market Funds)
30%
0.2
1.11
2.10
 
100%
-3.39
7.05
17.49

(Moderate Risk Portfolio)
Asset Mix
Bad Year
Normal Year
Good Year
Equity Funds
50%
-4.05
6.10
16.25
Bond Funds
30%
-0.81
1.71
4.23
Cash(Money Market Funds)
20%
0.08
0.74
1.40
 
100%
-4.78
8.55
21.88

(Agressive Portfolio)
Asset Mix
Bad Year
Normal Year
Good Year
Equity Funds
70%
-5.67
8.54
22.75
Bond Funds
20%
-0.54
1.14
2.82
Cash(Money Market Funds)
10%
0.04
0.37
0.70
 
100%
-6.17
10.05
26.27

The key input in the entire modeling process is based on historical data. With the global environment being so fluid and uncertain, there is every likelihood that future trends may deviate away from what we have been used to. But at least the given examples will give you a pretty good idea of what to expect in both the good times and when the market is not doing so well.

Tactical Asset Allocation Strategy

The entire process does not end with a “buy and hold” strategy once you have derived an appropriate asset allocation model. There are in fact two sets of circumstances under which the asset mixes may be modified. The first instance is when you have a short term view on the market. If, for example, you feel that stocks will do well in the short term, you may want to increase the overall portfolio weighting towards stocks (overweight). This short term deviation from the original asset mix is known as making a tactical asset allocation.

Tactical Asset Allocation for All Asset Classes

 
(Conservative)
(Moderate)
(Aggressive)
Equity Funds
10 - 50%
30 - 70%
50 - 90%
Bond Funds
20 - 65%
10 - 45%
10 - 30%
Cash(Money Market Funds)
10 - 60%
5 - 45%
0 - 40%

Tactical Asset Allocation for Equity Portion

 Equity Market Outlook
(Conservative)
(Moderate)
(Aggressive)
Bull Market
50%
70%
90%
 
40%
60%
80%
 
30%
50%
70%
 
20%
40%
60%
Bear Market
10%
30%
50%

The second instance is when the underlying assumptions change. As you grow older or personal circumstances change i.e. marriage, divorce, child birth etc. your investment needs will also change. Therefore, it is prudent to conduct regular review of your portfolio. However, this strategic asset allocation or long-term target benchmark should not be changed too frequently.

Lastly, by way of an example the table below should help you get started on the right track regarding asset allocation strategies.

Examples of Different Asset Allocation Strategies

 
Types of Investors
Investor's Profile
Portfolio Mix
 Somchai
 25 years old with a monthly salary of Baht 80,000. High job security with highly sought after skills. High risk tolerance that can withstand short-term volatility. 20% Agressive Growth Equity Fund; 50% General Equity Fund; 20% Balanced Fund (Equity/Bond); 10% Short-term Bond Fund.
 Sommai
 40 years old with Baht 50,000 salary. Stable job security. Prefers steady growth with some volatility. 10% Equity Fund; 30% Balanced Fund (Equity/Bond);50% Bond Fund;10%; Money Market Fund.
 Somboon
 Already retired at the age of 65, relying on income from savings. Needs stable income. 20% Equity Fund; 70% Bond Fund;10% Short-term Bond Fund.
 Somsak
 45 years old entrepreneur looking for short-term investment. Looking for short term cash management. 100% Short-term Bond Fund.

However, I must stress again that planning does not guarantee investment success but it puts the odds in your favour. The secret to investing is to invest for the long term and concentrate on the big picture. Stocks picking and market timing is good fun once in a while but it won't add any value to your long term returns. Hope this column is of some help and wish you every success for 2004 but if you still feel at a total loss about all this, then the best thing is to find yourself a good investment advisor.