Asset allocation is the foundation of a portfolio

When planning to build a portfolio, the usual questions include which assets to pick, which mutual funds (MF) to add and what about gold allocation, etc. But the portfolio construction begins somewhere else. A good portfolio isn’t about a collection of good investments. It’s a combination of assets designed around an investor’s goals, time horizon, risk capacity and future cashflow requirements. The objective is not to maximize returns at any cost but to achieve required financial outcomes without taking untoward risks.

The first step in portfolio is to understand the investor. The critical questions include what’s the money required for, when will it be needed, how much loss can the investor financially withstand, how much volatility can the investor emotionally tolerate and what other assets, liabilities and sources of income does the investor already have? The answers determine the portfolio.

A 30-year-old investing for retirement 25 years away can accommodate considerably more equity than someone who needs the money to fund a child's education three years from now. Similarly, someone with a stable pension and substantial financial assets may be able to take more investment risk than someone dependent entirely on the portfolio for current expenses.

But that doesn’t immediately assign the proportion of risk assets to be included in a portfolio. This is why a portfolio cannot be designed simply by assigning an investor a label such as “conservative”, “moderate” or “aggressive”. Probably each need could turn into multiple risk profiles for the same investor and change their risk profile at different periods of time.

An aggressive investor could turn into conservative during periods of income uncertainty or job loss. However, by separating allocations according to the time horizon of the requirement could help prevent a common mistake putting the entire portfolio into a single asset without considering the different requirements.

Once the objectives and time horizons are understood, the next question is asset allocation. It serves as the foundation. For example, a long-term moderate-growth portfolio might begin with something like 60 per cent equity, 30 per cent debt and 10 per centgold.A more aggressive long-term investor might have 75 per cent equity, 15 per cent debt and 10 per cent gold.

These are not universal prescriptions. The appropriate allocation depends on the investor's circumstances.The important point is that the allocation should be decided before selecting individual funds or securities.Once the asset allocation has been decided, the next step is to determine what goes inside each asset class.

A portfolio might includelarge-cap or broad-market exposure, diversified active funds, small-, mid-cap exposure and international equities too. But owning more funds does not necessarily mean having more diversification.Five mutual funds can collectively own many of the same companies. The investor may believe that the portfolio is diversified when it is concentrated in the same underlying businesses and sectors.Don't confuse diversification with the number of investments.

It’s not just equity but each asset has a role. Money required at a specific future date should not automatically be exposed to the same risks as long-term capital. While it seems like boring, debt can provide capital stability, liquidity, predictability and counterweight to portfolio volatility. Depending on the investor's needs, the debt allocation could include deposits, government securities, high-quality bonds, target-maturity products, EPF, PPF and other suitable instruments.But even within debt, risks differ. Credit risk, interest-rate risk and liquidity risk need to be considered.

Gold can play a useful role in a portfolio because its return drivers can differ from those of equities and bonds.But gold should not simply be added because its recent performance has been strong. Gold should’ve a defined purpose beforehand, primarily as a diversifier and potential hedge against inflationary, currency and other geopolitical crisis. For many investors, a relatively modest allocation may be sufficient.

Perhaps the most overlooked aspect of portfolio construction is the investor's total balance sheet.Portfolio construction should consider financial assets, real assets, liabilities and future income together.Looking only at the financial portfolio could give a very different picture from looking at the investor's entire economic position.

Remember that an investor's willingness to take risk and ability to take risk are not the same thing.Someone may say they are comfortable with a 30 per cent decline in their portfolio. But if they need the money next year, they may not have the financial capacity to tolerate that decline.

Another investor may dislike market volatility but have a stable income, substantial surplus assets and a 20-year horizon. Their financial capacity may be high even though their emotional tolerance is lower. So, risk-capacity is different from risk-tolerance, and a sensible portfolio must reconcile both.

In simple terms, risk tolerance tells us how much volatility an investor can emotionally live with. Risk capacity tells us how much risk the investor can financially afford.The portfolio should respect the more restrictive of the two.

Build the portfolio only after deciding the allocation. The sequence begins with goals, time horizon, risk, asset allocation then portfolio construction and product/investment selection. But, the usual mistake is to reverse this process with deciding an investment avenue and then trying to suit to the need or goal. This should be avoided.

Building a portfolio is only the beginning.Investors need rules for what happens afterwards.Rebalancing brings the portfolio back toward its intended risk level.Rebalancing does not always require selling.New investments can be directed toward underweight assets, gradually bringing the portfolio back toward its target allocation.

An investment or a fund needn’t necessarily be replaced simply because it underperformed for one year.There should be predefined reasons for replacement—such as persistent deterioration, change in mandate, significant process changes or other material concerns.Arguably, the most important portfolio rule may be the one written before a market crash.Investors often discover their true risk tolerance only after the portfolio has fallen sharply.

A good investment plan therefore specifies in advance what will happen when markets fall 10 per cent, 20 per cent or 30 per cent.The purpose of portfolio construction is not to predict which asset will perform best next year.It is to create a structure that can survive different economic environments, participate in long-term growth, provide liquidity when required and remain aligned with the investor's goals.

(The author is a partner with “Wealocity Analytics”, a SEBI registered Research Analyst and could be reached at [email protected])

ABOUT THE AUTHOR

K Naresh Kumar

K Naresh Kumar[email protected]