Risk Profile-based Asset Allocation
Research shows that nearly 80% of the returns generated via investments are made through the right choice of asset allocation. Whilst this statistic might seem easy to execute on the outside, taking a deep dive into how asset allocation works is not relatively straightforward. Even the most successful investors are not able to repeatedly perform asset allocation in the most efficient way. Investors want low risk but at the same time, want to maximize returns. This is not easy to achieve due to the trade-off that exists between risk and return. This is where asset allocation comes into play as it can help investors achieve maximum return for a given level of risk.
The reason for investors to diversify across asset classes is that different asset classes perform at different times. This is due to changes in expectations of the economy and how companies are anticipated to perform in the future. There might be a particular year or two where equities might outperform other asset classes and there might be a year where other asset classes would outperform equities. The reason for asset allocation is that despite having access to historical data, one cannot easily predict which asset class would perform the best in a given year. This is where asset allocation comes into the picture and is why a sensible investor should have a mix of different asset classes in their investment portfolio.
Diversifying across asset classes means that the investor’s portfolio would comprise of assets that have a low/negative correlation with one another, so when one asset class moves down, other asset classes would likely move either in the opposite direction (i.e. go up), be flat, or move down but at a lesser rate. This means that the investor’s portfolio would most likely never be in a situation where all of their holdings would be falling at a rapid rate at the same time.
Looking at the correlation matrix above, we can see a negative correlation between equity (rows 1–4) and debt (rows 5–7). A couple of the equity and debt pairs have a positive correlation but the relationship is very weak to indicate that they will move by the same magnitude. We can also see that gold has a negative correlation with all asset classes (it has a very weak positive correlation with Nifty 50 and Government T-bills). A negative correlation between two asset classes in this context implies that the two asset classes tend to move in opposite directions, providing a hedge to a portfolio consisting of a mix of gold and any other asset class. Hence, based on the illustration above, it is evident that having a portfolio comprised of different asset classes such as equity, debt, gold, and real estate does provide downside protection.
In order for asset allocation to work in an investor’s favour, the investor’s risk profile needs to be assessed so that the portfolio can be specifically catered to his/her risk profile. Looking at the risk profile above, an investor can be conservative, moderate, balanced, assertive (growth), or aggressive. After completing the risk assessment form, an investor will get a score between 0–100 and based on their score, they will get to know which category they lie in. The investment manager will also get the investor’s score and hence, that will allow both of them to be on the same page. The investment manager can therefore cater to the investor’s needs and provide them with a customized portfolio that matches their risk profile. In doing so, the investment manager strives to maximize returns but at the same time, ensures that the risk taken is at a level that the investor is comfortable with. For instance, if an investor completes a risk profile questionnaire and lies in the conservative category, the investment manager would ensure that their portfolio would strive to maximize returns only at a level of risk that they are comfortable with.
In the illustration above, the weights of each asset class are shown depending on the risk tolerance. It can be seen that there is a difference in weights allocated to different asset classes and hence the resulting portfolio return, risk, and Sharpe ratio vary. A conservative investor would want to take on a very low amount of risk so their portfolio would predominantly contain fixed income instruments, commodities (gold), and a small exposure to risk-averse equity instruments. In contrast, if an investor who completes the risk profile questionnaire lies in the assertive or aggressive category, their portfolio would predominantly consist of risk-seeking instruments such as equity investments in large, mid and as well as small caps and have some exposure to real estate instruments. The proportion of gold and fixed income instruments would be very low.
After trying out different weight combinations for every investor category, the combination of weights that maximized the Sharpe ratio whilst keeping in mind other requirements particular to the risk tolerance of the investor are shown in the image above. There is a very minor difference in weights between the assertive and aggressive investor predominantly since there was a cap on equity being 75% of the portfolio weight. Being extremely heavy on equities in a portfolio can turn out to be catastrophic during market downturns. Another trend observed is that as the investor risk tolerance increases, the weight of equity increases whilst the weight of debt increases, resulting in an increase in portfolio return, risk, and Sharpe ratio.
Hence, based on the illustration above, the most important step in asset allocation is that the investor’s risk profile needs to be understood by both the investor as well as the portfolio manager. Simply trying to maximize return does not bode well if an investor’s risk tolerance is extremely low. Due to the plethora of investment instruments such as equity, debt, commodities, and real estate, different weights can be given to each instrument in order to cater to an investor’s risk profile, financial goals, and time horizon that they wish to remain invested for. Using the Markowitz mean-variance portfolio optimization approach, a portfolio manager can try out different weights for each asset class and strive to maximize returns at a specified level of risk. The efficient frontier is the “set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return”.
In the figure below, any point that lies on the curve is considered efficient because it strives to maximize returns at that particular risk level. Different weight combinations were tried for each investor type and as indicated above, the combination that maximized the Sharpe ratio was the one chosen. Hence, once different combinations of weights are tried out, a portfolio that lies on the optimal portfolio curve or one that is just slightly beneath it should be chosen rather than one that lies very far down.
As indicated at the beginning, asset allocation is an extremely difficult skill for even the most seasoned investors to master. Since different asset classes perform at different time periods and timing the markets is not an easy skill, the importance of asset allocation cannot be overlooked. In addition, knowing how to allocate assets according to an investor’s risk profile is an extremely important skill since that would mean that the portfolio constructed is catered to the investor’s risk tolerance and is in line with his/her financial goals. In conclusion, all the above instances show us the importance of asset allocation and why it is extremely vital that it is done in the right way.
By Arhan Parikh (email@example.com)