Explaining the optimal asset allocation to clients - Pocket Risk

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Explaining the optimal asset allocation to clients

The asset allocation of a portfolio is an important aspect as it determines its structure and the varied types of assets that are included in its composition. Before including an asset in his portfolio an investor has to think it through in order to determine if it is suitable to his risk tolerance and required rate of return. It is expected that riskier assets have greater returns so the investor must decide how much risk he can take for a fixed increased in return.

Asset allocation combines several asset classes in a portfolio in order to achieve a tradeoff between risk and return. Low risk assets such as bonds and currencies will be included as well as high risk assets such as stocks. The risk is expressed in terms of market volatility and this can be both a blessing and a curse, as an investor can take advantage of market volatility in order to maximize his earnings or accumulate losses because of it. The notion of risk does not imply a fixed cost that has to be paid for a percentage increase in return but rather it depends on the interpretation of the individual. There are investors who can take on greater risks than others for the same returns.

The asset allocation of a portfolio should depend on the attitude toward risk and market volatility of the investor. There are a lot of assets that can be included in a portfolio, such as index-funds, exchange-traded funds, mutual funds, individual securities or bonds. The choice of including an asset should be made by examining the characteristics of the asset such as return, risk and performance indicators and determining if it is suitable to the objectives and preferences of the investor.

In order to describe the optimal asset allocation, an adviser should not refer to theoretical concepts such as modern portfolio theory, the Markowitz frontier and the covariance matrix. The main reasoning for this is that even if these concepts have theoretical value they are not used in practice. Hedge fund managers, brokers and investors usually don’t use the covariance matrix, because there are too many assets in the market so that the covariance between two of them has no meaningful interpretation. The modern portfolio theory also uses expected values that are mathematical statements about the future based on historical data. Often these expected values don’t predict the future well as they fail to take in account events that did not exist when the historical data was collected and considered to be relevant.

The best way to explain optimal asset allocation is to concentrate on what works and what is used in practice. At its core, asset allocation is an organized and effective way to carry out diversification. This can be accomplished by separating the portfolio across asset classes.

The main three classes of assets are stocks, bonds and cash. In addition to these there are subclasses that are presented below sorted according to risk in an ascending order:

1) Money market securities are debt securities that can easily be cashed out and have maturities of less than one year. They consist mostly in treasury bills.

2) Fixed income securities pay the holder a set amount of interest as well as the return of principal at maturity. They have lower volatilities than equities but there is still the risk of default. Examples include corporate and government bonds.

3) Large-cap stocks are issued by companies with a market capitalization above $10 billion.

4) Mid-cap stocks are issued by companies with a market capitalization between $2 billion and $10 billion.

5) Small-cap stocks represent smaller companies with a market capitalization of less than $2 billion. Equities such as these tend to have the highest risk but also the greatest potential for growth.

The differences between these assets results in the tradeoff between risk and return. Because assets have different risks and fluctuations, the asset allocation can protect the entire portfolio from the price evolution of a single class of securities.

In order to make the asset allocation process easier for clients, a series of model portfolios can be created, each having a different structure. These portfolios can range from conservative to very aggressive. Conservative portfolios are designed to protect the principal value of the portfolio. They consist mostly in fixed income securities but they can also have 15% to 20% invested in quality equities such as large-cap stocks. Aggressive portfolios have an increased percentage of equities and a lower percentage of fixed income securities and cash.

The optimal portfolio that should be recommended to an investor will depend on his investment objectives, available capital and time horizon. Investors with a long time horizon and greater capital can choose portfolios with high risk and return. Investors with shorter time spans and lower capital will likely choose portfolios at the opposite end of the spectrum.

The purpose of asset allocation is portfolio diversification and so it should be presented. Because a part of the portfolio contains more volatile securities, the other part should remain stable. Because of this protection, the key of asset allocation is to minimize risk while maximizing returns. Knowing that his savings do not depend on a single asset class should make the investor more confident, regardless of the risk tolerance. A carefully balanced portfolio should be easy to promote and recommend while still having inherent qualities.