Table of Contents

Importance of Asset Allocation Decision

Asset allocation is an important investment strategy that involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The goal of asset allocation is to create a diversified portfolio that balances risk and return, and is aligned with the investor’s financial goals, time horizon, and risk tolerance.

Asset allocation decisions are crucial because they can have a significant impact on the overall performance of an investment portfolio. The right asset allocation strategy can help to maximize returns while minimizing risk, and can help investors to achieve their long-term financial goals. On the other hand, poor asset allocation decisions can result in lower returns, higher risk, and potentially significant losses.

Furthermore, asset allocation decisions are not a one-time event. As an investor’s financial goals and risk tolerance change over time, so should their asset allocation strategy. Regularly revisiting and adjusting asset allocation decisions is critical to ensuring that the investment portfolio remains aligned with the investor’s changing needs and objectives.

Understanding correlation across asset classes and securities

Correlation measures the relationship between different assets or securities. A high positive correlation means they tend to move in the same direction, while a high negative correlation means they tend to move in opposite directions. Understanding correlation can help investors build a diversified portfolio and identify potential risks and opportunities.

Investment Policy Statement (IPS)

Steps in the Portfolio Construction Process:

  1. Develop an Investment Policy Statement (IPS) that identifies the investor’s risk appetite and defines investment objectives, goals, and constraints.
  2. Study current financial conditions and forecast future trends.
  3. Construct the portfolio based on the IPS and financial market forecasts, and monitor and rebalance it continuously.
  4. Measure and evaluate the portfolio’s performance.

Investment Policy Statement (IPS):

The IPS is a crucial step in the portfolio management process, as it guides the investment process by specifying investment objectives, goals, constraints, preferences, and risks. It forms the basis for strategic asset allocation and all investment decisions are made considering the IPS. The IPS needs to be updated and revised periodically to reflect changes in the investor’s requirements.

Need and Importance of IPS:

The IPS is an important planning tool that helps investors understand their requirements and portfolio managers create and maintain optimal portfolios for the investors. It also reduces the possibility of making inappropriate decisions and protects the investor against inappropriate investment decisions or unethical behavior. The four important purposes of the policy statement are to enable realistic return expectations, effective investment decisions, evaluation of investments, and protection against inappropriate investment decisions.

Constituents of IPS:

The IPS should be prepared with caution and list out the investor’s goals and priorities, investment objectives, time horizon, risk/return profile, liquidity constraints, and preferred asset classes. The IPS should also include a systematic review process to ensure the investor remains on track to achieve their goals, and up-to-date information is critical to the entire structure. The advisor or manager preparing the IPS should obtain a deep understanding of the investor’s profile.

Investment Objectives-

Investors have different investment objectives that are related to risk, return, and liquidity. They may express their objectives in terms of desired returns either in an absolute or relative sense. Investors should keep in mind that risk and return are usually positively related, with higher risk leading to higher returns. However, liquidity has an inverse relationship with return, and less liquid investments require an illiquidity risk premium.

Investors generally invest for capital preservation, regular income, and capital appreciation. These investment objectives inform their asset allocation decisions. For instance, if the objective is capital appreciation, investors may invest in high-return investments like equity, which carry higher risk than government securities or bank fixed deposits. Conversely, if the primary objective is capital preservation, investors may allocate their assets toward safe bonds and debt securities. Finally, if regular income is the objective, investments will be made in asset classes that generate periodical income, such as dividend-paying stocks, interest-paying bonds, or rent-paying real estate.

Investment Constraints-

Investment Constraints refer to limitations that investors face in taking exposure to certain investment opportunities. These constraints relate to investors’ liquidity needs, time horizon, and unique needs and preferences.

One common constraint is the Liquidity Constraint, which refers to the amount of liquid funds an investor needs to meet their day-to-day expenses and contingency requirements. Emergency cash reserves are usually measured at two to three months’ spending, but it could be more if the individual’s source of income is at risk or volatile. Near-term goals require assets with relatively good liquidity and less risk, while investment flexibility requires greater liquidity to take advantage of market opportunities.

Regulatory Constraints are limitations imposed by regulatory bodies that investors must follow. For example, the Reserve Bank of India’s notification on the Liberalised Remittance Scheme limits an Indian resident individual’s overseas investments to $250,000 per year. Another example is the prohibition of trading on insider information.

Tax Constraints also play an important role in portfolio management and investment decisions. Different investments and types of income are taxed differently, and understanding tax laws applicable to the investor is crucial.

Exposures limits to different sectors, Entities and Asset Classes-

According to SEBI PMS Regulations 2020, the investment approach must be outlined in the agreement between the portfolio manager and the investor. This approach should consider factors specific to the investor and securities, including the type of securities and permissible instruments to be invested in, as well as the proportion of exposure. Exposure limits to specific sectors, entities, and asset classes can be set to avoid concentration risk, taking into account the investor’s objective, risk appetite, liquidity needs, tax and other regulatory constraints, and time horizon for investment. The portfolio manager must follow these exposure limits while managing investments.

Unique needs and preferences-

Investors may have unique needs and preferences that should be taken into consideration when creating an investment portfolio. These may include personal, social, ethical, cultural, and other beliefs. For example, an investor may want to avoid investing in companies that sell environmentally harmful products, or they may be emotionally attached to owning stocks of the company they work for and be reluctant to sell, even if it is financially prudent. It is important for these preferences to be clearly specified in the IPS. Additionally, the IPS may include reporting requirements, portfolio rebalancing schedules, frequency of performance communication, investment strategy, and styles, among other things.

Learn about sustainable investing-

Sustainable investing is a growing trend worldwide where investments are selected based on environmental, social, and governance (ESG) criteria. The aim is to generate financial returns while also making a positive impact on society. This approach is driven by personal values, institutional mission, or investor needs. Investments are compared based on ESG criteria and checked for future readiness to address emerging challenges. There is also a growing belief that focusing on ESG factors leads to financial outperformance. Governance factors include board independence, diversity, and executive compensation; social factors include workplace safety, community development, and human rights; and environmental factors include pollution, water use, and clean technology.

Ethical investing is the process of selecting investments based on moral or ethical principles. The primary filter for selecting investments is based on ethical principles, which vary depending on the investor’s views. Ethical investing is often used interchangeably with sustainable or socially conscious investing, but there is a key difference between the two. While the latter is based on an overall set of guidelines that screen out investments, ethical investing is more personalized. Therefore, ethical investing typically avoids sin areas such as gambling, alcohol, smoking, or firearms.

Assessments of needs and requirements of investor-

Understanding the needs and requirements of investors is crucial in making investment decisions. Investors have a variety of financial goals, which may be short-term, medium-term or long-term, and each goal may have a different priority level. To assess these needs and goals, investors can create a goal sheet that includes the number, the goal, its priority level, the time period for achieving it and the amount needed.

Near-term high priority goals are those with a high emotional priority that investors wish to achieve within a few years. These goals typically require investment vehicles that are low-risk and have maturity dates that align with the goal date. Cash equivalents or fixed-income instruments may be suitable for these goals, particularly for investors with limited or modest means.

For many investors, building a retirement corpus is a long-term high priority goal. Diversified investment approaches utilizing multiple asset classes are usually preferred for these goals due to their long-term nature.

Investors may also have low-priority goals that are not particularly painful if they are not achieved. These goals may include purchasing a farm house or a luxury car, and for these goals, more aggressive investment approaches may be taken.

Analysing the financial position of the investor

To analyze the financial position of an investor, a personal financial statement can be helpful. This includes a balance sheet that lists all assets, such as house, car, investments, and savings, at their market value minus liabilities such as loans. Calculating net worth periodically, at least once a year, can help track progress. An income-expense statement can also be prepared to determine how much income exceeds spending and is available for investment purposes. This can be done on a monthly basis.

Psychographic analysis of investor-

The behavioural traits and personality characteristics of an investor play a significant role in their risk profile. Psychographic analysis of investors is a way to understand their behaviour and identify biases and cognitive errors. There are many frameworks available for psychographic analysis, and one such framework is the Bailard, Biehl & Kaiser (BB&K) classification system. This system classifies investors based on their level of confidence and method of action. The different personality characteristics are adventurer, celebrity, individualist, guardian, and straight-arrow investors. Each personality type requires a different approach in portfolio management. It is important to note that investors can exhibit characteristics of multiple personality types, and their recent investment experiences can influence their behaviour.

Life cycle analysis of investor-

An investor’s life cycle can be divided into four phases: accumulation, consolidation, spending, and gifting. In the accumulation phase, the investor’s net worth is small and high-return, high-risk investments may be taken on. During the consolidation phase, the investor’s income exceeds expenses and investments become more diversified, with a focus on capital preservation. In the spending phase, living expenses are covered by accumulated assets, and the focus is on stability in the investment portfolio with a preference for investments generating dividend, interest, and rental income. In the gifting phase, excess assets may be used for leaving a legacy or supporting a charitable cause. The boundaries between these phases are not exact and may vary for each individual.

Phase Characteristics
Accumulation Phase Net worth is small relative to liabilities. Investments are few and typically non-diversified. High-risk, high-return investments are possible.
Consolidation Phase Income exceeds expenses. Time horizon to retirement is still relatively long. Investors start looking for capital preservation. Balanced portfolio.
Spending Phase Living expenses are covered from accumulated assets such as investments and retirement corpus. Focus on stability and income generation.
Gifting Phase The investor has more assets than they will need for spending. Investments may be made to leave a legacy or support a charitable cause.

This table provides a summary of the main characteristics of each phase, including the investor’s net worth, investment diversification, risk appetite, time horizon, and investment goals.

Forecasting risk and return of various asset classes-

Portfolio management involves combining two sets of information: the first being investment objectives, goals, requirements, personality type, phase in the life cycle, liquidity needs, tax, and other constraints; the second being capital market forecasts that determine the expected risk-return opportunities available to investors. To make forecasts about future return possibilities, it is necessary to list the various investment opportunities available to investors and forecast their returns along with the possibilities of deviations in those returns. Historical risk-return on different asset classes can provide a starting point for understanding the relationship between risk and return and making future return forecasts.

Benchmarking the client’s portfolio-

Benchmarking the client’s portfolio involves selecting a benchmark portfolio that matches the composition of the investor’s portfolio, in order to compare “apple with apple”. This benchmark serves as a framework for evaluating the performance of the portfolio. Selection of the appropriate benchmark is crucial to evaluate the performance of the investor’s portfolio. For instance, a large cap portfolio should be compared to a large cap index and a mid-cap portfolio to a mid-cap index. Similarly, a debt portfolio needs an appropriate benchmark that represents the nature of the investments made. In some cases, hybrid benchmarks can be used to better represent the entire situation. It’s important to review the selected benchmark regularly to ensure it’s still appropriate and to change it if necessary due to changes in the nature of the investment or benchmark composition.

Asset allocation decision

The process of asset allocation involves considering information about the investor and investment opportunities to make decisions about how to allocate assets. This decision is based on the investor’s goals, risk preferences, and liquidity needs. After forecasting the risk and return on different asset classes, the portfolio manager must determine the optimal mix of assets that will provide the highest after-tax returns for the investor.

Portfolio Construction Principles

The portfolio construction process is based on the needs and goals of the investor, as well as the time period in which those goals need to be achieved. The investment adviser can help construct a portfolio by following several principles.

Type of Portfolio Description
Equity portfolios Should have the right mix of risk and stability based on the investor’s risk-taking ability. Large cap exposure provides stability, while mid and small caps may lead to higher capital appreciation. Higher dividend yield stocks can also generate cash flow from equities.
Debt portfolios Should generate a steady cash flow from investments by choosing specific kinds of instruments. Short-term debt instruments are suitable for meeting short-term goals. Credit risk tolerance of the investor will determine the type of instruments included in the medium to long-term debt portfolio.
Hybrid portfolios Provide stability and potential upside in case of better asset performance. They are meant to achieve a specific long-term goal and can replace separate equity and debt mixes. The shift to such portfolios ensures a smooth transition for the investor in terms of their asset allocation mix.
Other portfolios Can include assets like gold or other precious metals, as well as alternative investments. These portfolios aim to increase overall returns while providing diversification, reducing risk, and maintaining stability.

Strategic versus Tactical Asset Allocation-

  • Strategic Asset Allocation (SAA): long-term target allocation among major asset classes based on investor’s characteristics and investment policy statement.
  • Tactical Asset Allocation (TAA): short-term shifts in asset allocation to take advantage of market opportunities and exploit discrepancies between asset classes.
  • SAA decisions involve “time in the market,” while TAA is for “timing the markets.”

Importance of Asset Allocation Decision – Empirical Support

  • Asset allocation is the most important investment decision as it determines the risk and return of a portfolio.
  • Brinson, Hood, and Beebower (1986) and Ibbotson, Roger G., and Paul D. Kaplan (2000) found that asset allocation explains a significant portion of return variability in diversified portfolios.
  • Across all portfolios, asset allocation explains an average of 40% of variation in fund returns, while for a single fund, it explains 90% of variation in returns over time.

Rebalancing of Portfolio-

Portfolio rebalancing is necessary to maintain the original risk-and-return characteristics of the portfolio and align it with the investor’s goals and risk tolerance. The Investment Policy Statement should include a policy on rebalancing the portfolio, outlining the frequency and tolerance for deviation from the target portfolio. Rebalancing involves a trade-off between the cost of rebalancing and the cost of not rebalancing. Transaction costs and tax costs are associated with rebalancing, and illiquid investments may present challenges. Rebalancing is easier with more liquid assets, such as listed equities or government bonds.

Mock Test:-

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NISM-Series-X-A: Investment Adviser (Level 1) Certification


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1. Risk-neutral investors evaluate investment opportunities solely based on

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2. A hedge fund classifies as a ____________

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3. True or False: The portfolio variance formula considers the weighted averages of individual variances and covariances between assets in the portfolio.

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4. What is the concept of the Efficient Frontier in portfolio optimization?

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5. Exchange Traded Funds (ETFs) are ____________ investments

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6. The hurdle rate is the rate which has to be crossed in order to charge

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7. What can be done with the un-invested portion of the investable funds of an AIF?

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8. Under the advisory model of PMS, the execution has to be done by the

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9. The Certainty Equivalent Rate (CER) is the rate that a risk-free investment has to offer to be equally attractive with

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10. What is the process of portfolio optimization?

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11. A risk-seeking investor in Modern Portfolio Theory is willing to engage in

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12. How many correlation estimates are required for a portfolio of 50 securities?

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13. Which investment category showed the highest growth in the AIF industry?

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14. In portfolio optimization, what is the purpose of specifying investment constraints?

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15. What is the minimum continuing interest required from the Manager or Sponsor in an Alternative Investment Fund?

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16. What is the maximum percentage of investable funds that a Category I or II AIF can invest in one Investee Company?

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17. Modern Portfolio Theory (MPT) provides a framework for constructing and selecting portfolios based on

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18. The interest rate risk in a debt fund will depend on

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19. Which of the following is a risk of investing in an alternative investment fund?

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20. Modern Portfolio Theory assumes that investors maximize

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21. Can units of a close-ended Alternative Investment Fund be listed on a stock exchange?

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22. Investors withdrawing a fixed sum of money each month are using the

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23. What is the regulatory body that issued the AIF Regulations in India?

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24. In Modern Portfolio Theory, investors estimate the risk of a portfolio based on

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25. How many investors can a scheme of an Alternative Investment Fund have?

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26. What is the calculation involved in portfolio risk comprising more than two securities?

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27. Risk averse investors in Modern Portfolio Theory prefer

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28. What is the minimum investment value for an investor in an Alternative Investment Fund?

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29. True or False: Portfolio optimization using the MPT framework requires accurate estimation of statistical inputs.

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30. In a fund of fund, the portfolio consists of

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31. A private equity fund invests in ____________

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32. Utility curves in Modern Portfolio Theory demonstrate

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33. The PMS provider has to appoint a ____________ compulsorily

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34. What is the key factor that determines the selection of an optimum portfolio from feasible combinations?

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35. Which of the following statements is true regarding the Modern Portfolio Theory (MPT) framework?

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36. What is the minimum corpus required for each scheme of an Alternative Investment Fund?

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37. What is estimation risk in portfolio management?

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38. An AIF consists of ____________ funds

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39. Can an Alternative Investment Fund invest in associates without investor approval?

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40. According to Modern Portfolio Theory, investors want to maximize the return for a given level of

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