Why is Asset
Allocation so Important?
|
In
1952, Harry Markowitz floated an innovative theory, known as Modern Portfolio
Theory (MPT) for which he received a Nobel Prize in Economics. MPT basically
demonstrates why putting all your eggs in one basket is an unacceptable risky
strategy and why investors get benefits from diversification. The theory has
been used widely across the world for more than five decades but of late it has
received wide criticism following the global financial crisis in 2008 when all
asset classes heavily suffered the same fate of severe meltdown.
Many
investors sold heavily during the market crash of 2008 – but they did not reinvest
when the markets were extremely cheap in that period. After March 2009, the markets
recovered spectacularly and many investors could not benefit from the large upswing
in asset prices.
A
few studies in the 1980s and 1990s have shown that asset allocation explained
more than 90 per cent of the variation of returns over time for large pension
funds. Another study done in 2000 found that about 40 per cent of the variation
of returns across funds was explained by asset allocation policy and the
remaining 60 per cent was explained by factors such as market timing, security
selection, fees and investment style.
Whatever
be the percentage, asset allocation still is very important for investors, who
have to take into account their return objectives in line with their own risk
appetite. It would be beneficial for long-term investors to invest across asset
classes.
In
my village where I was born, a typical middle class family was following a
simple asset mix plan. In the1970s and 1980s, the family’s homemaker would buy
gold ornaments and house furniture while the husband would invest in property
or land – a simple asset mix without knowing it! Now that land and gold prices
have soared, these middle class rural people proved to be much smarter than you
and me!
Related: Understanding Asset Allocation 14Oct2012
What is the Suitable Asset Allocation?
|
Rakesh Jhunjhunwala is a well known equity investor from Mumbai , India
Obviously, his allocation is not suitable for others. The allocation differs from person to person or institution to institution. No emotions should be involved while choosing asset mix. Let us take a hypothetical example.
Mike Gates from the US
His risk tolerance is above average and expects to receive above average returns from the investment. He wants to retire by age 60 and would like to invest the surplus for his retirement needs. He requires a little liquidity for his lifestyle needs. It is assumed that he has no tax concerns. He has no other constraints, like supporting a family financially.
What kind of asset allocation would be suitable to Mike Gates? Mike is young and the potential to earn future income is very high. His risk tolerance and expected return are above average and as such he can put a higher share in equities, say 65 per cent of $1,000,000 surplus. The remaining can be put in bonds, real estate and commodities. Periodic interest from the bonds (fixed income) and salary income will take care of his liquidity needs. The following asset allocation is suggested for Mike:
Note: The above graph is only for illustrative purposes
- - -
Disclaimer:
The author is an investment analyst, equity investor and freelance writer. This
write-up is for information purposes only and should not be taken as investment
advice. Investors are advised to consult their financial advisor before taking
any investment decisions. He blogs at:
No comments:
Post a Comment