WE often must have heard about the term “middle path”. What do we actually mean by the term ‘middle path’? In simple terms it means when something is not lopsided but balanced.
Take this logic further, quite often you must have heard the famous saying that – “excess of anything is bad”. If we can reverse this situation then this saying would somehow read as follows – “shortage of anything is bad”.
So one side it depicts that excess is bad, while on other side it equally proves that even shortage of anything is also bad.
Such a situation would generate confusion for a common man when one has to determine what constitutes the best asset allocation mix - which is neither in excess nor short.
This leads us to believe that neither excess nor short of anything is good and thus we need to maintain a balanced or optimum level.
The terminology – “optimum level” applies more commonly to investment matters than to any other thing.
Thus in order for us to maintain an optimum level, we need to focus on one important factor of our investment strategy and that key element is known as – “Asset Allocation”.
In simple terms - “Asset allocation” is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio, according to the investor’s risk tolerance level, goals and investment time frame.
Many financial experts say that asset allocation is an important factor in determining returns for an investment portfolio, as asset allocation is based on the principle that different assets perform differently in different market and economic conditions.
You would agree that whenever we commence a talk on any investment related matter, two factors emerge naturally i.e. ‘Risk’ and ‘Return’.
These two factors are so important that no sensible decision on any investment related matter can be taken without giving due consideration to them i.e. risk and return.
That being the case, there is an urgent need to make a riskreturn tradeoff while handling investment matters of any magnitude.
For example investment into equities is known for its risks, but at the same time this wonderful instrument is also known for generating comparatively superior returns on a long term basis.
This tradeoff maintains that potential return rises with an increase in risk, as low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns.
According to the risk-return tradeoff, invested money can render higher profits only if it is subjected to the possibility of being lost.
Because of the risk-return tradeoff, you must be aware of your personal risk tolerance limit when choosing investments for your portfolio.
Taking on some risk is the price of achieving comparatively better returns; therefore, if you want to make money, you can’t cut out all risk.
The goal instead is to find an appropriate balance - one that generates some profit, but still allows you to sleep peacefully at night.
And to achieve the so called optimum level of risk-return tradeoff one has to focus invariably on the ‘asset allocation’, which one maintains for its investments.
When I say focus on your ‘asset allocation’, what I basically mean is that you need to review the asset allocation basket to ensure that the same is aligned with the corresponding risk you intend to take and investment returns one is expecting.
Again both these factors i.e. risk and return have to be determined keeping in view one’s financial goals in life. Playing safe is good but playing too safe will not take you far.
Thus some element of risk is also important but that risk must be calculated and not to be taken blindly. So the moot question remains as to how we can realign the asset allocation mix in order to reach an optimum level.
This is easier said than doing. But if we make sincere efforts, the optimum asset mix level can be achieved by application of four basic types of asset allocation strategies, which are based on investment goals, risk tolerance, time frames and diversification respectively.
The first one is called ‘Strategic Asset Allocation’, the primary goal of which is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon.
The second strategy is called – ‘Tactical Asset Allocation’ where an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for gains.
The third strategy is called ‘Core-Satellite Asset Allocation’, which is more or less a hybrid of both the strategic and tactical allocation method as mentioned above.
And the last one is called – ‘Systematic Asset Allocation’ which mainly depends on three assumptions - (a) the markets provides explicit information about the available returns; (b) the relative expected returns reflect consensus; and (c) expected returns provide clues to actual returns.
A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated; hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return.
Therefore, asset diversification has been described as “the only free lunch you will find in the investment game”.
And mind it, asset diversification of any nature can be implemented only when one focuses on the asset allocation.
Thus it is imperative on the part of any sensible investor to review the asset allocation mix at regular interval and realign it time and again with one’s risk-return appetite.
And finally not to forget the ultimate goal post, which is nothing but successful attainment of financial goals as set by you – whether short term or long term goals.