Asset Allocation

By: IDFC AMC

IDFC AMC

What is Asset Allocation?
 

  • Its diversification of one’s portfolio among different asset classes such as bonds, equity, cash, commodities, real estate in order to minimize risk and maximize return.
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  • Different assets perform differently in different market and economic conditions. In other words, returns from different asset classes do not always move in tandem.
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  • Asset allocation minimizes risk.
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  • The best asset allocation is the one which maximizes return with minimum risk in line with investors profile and objectives.
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  • Key to asset allocation is to choose the right asset class to invest in and allocating the right percentage of the total investment to each asset class.
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1 year Rolling Return* Minimum Maximum Average Risk**
Gsec -8.3% 31.6% 9.4% 8.4%
Equity -53.0% 95.7% 17.1% 33.5%
Gold -9.2% 54.6% 17.1% 14.0%

 
Relation between Asset Classes
 

  • Asset returns can be directly correlated (move in same direction) or are inversely correlated (move in opposite direction).For example, one asset class could give positive return while another asset class could give negative return in the same period of time. These two asset classes are inversely related.
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  • Gsec# and equity are inversely correlated.
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  • Correlation coefficient^ of Gsec v/s equity is -0.44. The chart below shows the relation between Gsec and Equity returns.
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Asset Allocation of the two Asset Classes
 

  • Chart below shows risk-return profile of different combinations of asset allocation in Gsec and Equity.
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Learning’s from the Graph
 

  • Investing only in Gsec, gives a return of 9.4% with risk of 8.4%.
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  • By increasing allocation to equity to 15 % the risk actually reduces with an increase in returns. An 85:15 (Gsec: Equity) ratio gives us 10.5% return with lowest level of risk of 6.7%.
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  • Increasing equity allocation a little further to 25 % has the same risk as a 100 % G sec investment but a 2% higher return. A 75:25 (Gsec: Equity) ratio one gets higher return of 11.3% and risk of around 8%.
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  • Choosing right asset class to invest is alone not sufficient. One needs to also decide the right % to allocate to each asset class in order to get maximum return with lower risk.
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Adding Gold as asset class to Gsec and Equity
 

  • We have considered a 2 asset model. By adding another asset class viz. gold risk could reduce further.
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  • Tables below show the risk return relation difference between using diversification of the Gsec: Equity combinations and Gsec: Equity: Gold combination.
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