There are no short cuts to investing and more often than not investors burn their fingers in trying to time the market. My advice therefore to all investors with long-term investment goals is to follow disciplined investing with a risk reward balance. It definitely pays.
We all know of the proverb "Don't put all your eggs in one basket", similarly investors should diversify investments across asset classes, markets, managers, tenor, etc. to achieve desired returns with lower risk at the portfolio level.
Diversification involves dividing an investment portfolio among different asset categories, such as equities, fixed income and alternate investments. The process of determining which mix of assets to hold in a portfolio varies from investor to investor and also on the investment objectives.
If the portfolio has the right allocation, it will be well on its way to deliver the investment goals (with an acceptable amount of risk factored in).
Therefore, before making any investments, investors should define an investment philosophy and assess their investment objective, risk profile and suitability.
Your investment objectives need to be set, based on factors such as personal wealth level, age, family circumstances, investment/financial goals, need for regular income streams, understanding of asset classes and risk reward payoffs, conventional versus alternate assets such as art, commodities, real estate.
Some other factors include loss bearing ability, past investment experience time horizon of the investment, liquidity needs, proportion of liquid net worth in a high risk/locked-in product, tax status, inflation and market outlook.
The asset allocation that works best for an investor will depend largely on the time horizon and his/her ability to tolerate risk. Investors should pay attention to structural considerations such as financial planning, trusts, insurance and annuities, and tax and liability management.
Once an investor has decided on the investment objective and risk profile, asset allocation would include all or most of the following considerations/steps:
• Document all the assumptions made
• Calculate rates of return, standard deviation and correlation between different asset classes
• Check for consistency of returns across economic cycles & time periods
• Select the asset mix that would optimize the risk reward payoff – minimum risk for the desired return
• Agree on the benchmarks to be used for comparing performance results and degree of tracking vs. benchmarks
• Decide if the investments are to be made on a staggered manner (in 3 to 4 installments), recommended in volatile markets
• Implement the desired asset allocation through best in class products based on net of tax expected returns
• Evaluate portfolio hedging options and cost
• Active versus Passive management
• Periodic review and rebalancing
Asset allocation has evolved over time. In its initial stages of evolution, this was a simple philosophy of spreading eggs across baskets to spread losses. It then moved to a more complicated mathematical model where the amount of allocation to be made to each asset class was made based on the risk-return framework and correlation between asset classes.
In its more modern form, asset allocation is a more forward looking exercise which lays significant importance to qualitative overlay. This qualitative overlay is derived from experts and it makes asset allocation a more relevant exercise in today’s time, than a traditional quant-based asset allocation.
This overlay can be in terms of analysis of geo-political events, macro economic indictors, market sentiment, or any other factor that cannot be captured by standard risk metrics such as standard deviation of an asset class.
With this evolution in the area of asset allocation, comes into play the role of Tactical Asset Allocation. Tactical Asset Allocation, to some, is essentially about market timing. To my mind, however, it is not market timing but is a dynamic strategy that actively adjusts a portfolio’s asset allocation by taking an informed call on the portfolio in reaction to or in anticipation of the certain trends.
While the importance of long term investments and therefore strategic asset allocation cannot be undermined, in today’s markets, tactical asset allocation, if followed with rigor can certainly deliver alpha (incremental returns) to an investor’s portfolio.
Once invested, one should periodically review and rebalance investments if required. Investors should have pre-defined Profit & Loss booking levels based on their profiles. These levels should be periodically reviewed and reset based on market outlook.
Investors should also maintain certain liquidity in the portfolio to take advantage of sudden opportunities. In addition, investors could consider maintaining separate trading and investment portfolios with different investment objectives.
With increasing globalization, complexity, volatility and lack of time and/or expertise, smart investors always engage professional investment advisors to manage their portfolios. Good Investment Advisors have developed the skill, insight, perspective, and common sense needed to recognize when assets and/or markets may be entering cyclical and secular turning point.
Finally the most crucial factor of disciplined investing - never get emotionally attached to your investments. There is no harm in booking profits and staying liquid. Markets will always give opportunities to make returns from investments in the future.
David M. Darst, Chief Investment Strategist at Morgan Stanley Smith Barney says, "Rather than attempting to time the market in a limited number of asset classes, asset allocation seeks, through diversification, to provide higher returns with lower risk over a sufficiently long time frame and to appropriately compensate the investor for bearing non-diversifiable volatility."
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