Asset Allocation: "A Powerful Approach To Long-Term Investment Success"

Asset Allocation
“A powerful approach to long-term investment success”

Dilemma for investor
• Equity gives better returns but is also the most volatile
• Steep losses in short-term can derail the long-term

objectives of the portfolio.
• It is Impossible to predict market moves

Dilemma for investor
Annual Returns (Calendar Year) For Key Indices & Gold (INR) Price (1998-2009*)
Ranked In Order of Performance (Best To Worst)
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009*
CNX Nifty CNX Nifty Gold Price Gold Price Gold Price CNX Nifty CNX Nifty S&P CNX S&P CNX CNX Nifty Gold Price CNX Nifty
Junior Junior INR INR INR Junior Junior Nifty Nifty Junior INR Junior
25.09% 159.99% 3.76% 4.74% 22.7% 144.31% 27.05% 35.39% 38.17% 74.74% 26.51% 124.01%
Gold Price S&P CNX S&P CNX S&P CNX CNX Nifty S&P CNX S&P CNX Gold Price CNX Nifty S&P CNX S&P CNX S&P CNX
INR Nifty Nifty Nifty Junior Nifty Nifty INR Junior Nifty Nifty Nifty
8.21% 66.05% (23.17%) (16.81%) 9.27% 72.49% 6.93% 24.8% 26.4% 53.54% (52.21%) 73.63%
S&P CNX Gold Price CNX Nifty CNX Nifty Gold Price Gold Price CNX Nifty Gold Price Gold Price CNX Nifty Gold Price
S&P CNX
Nifty INR Junior Junior INR INR Junior INR INR Junior INR
Nifty 3.10%
(18.68%) 3.34% (46.41%) (47.14%) 15.97% 0.45% 22.61% 20.24% 16.42% (64.82%) 31.30%
Note: (1) The above returns are CAGR(%). (2) Gold (INR) price is arrived based on London AM Fix (Price In $) and RBI
INR/USD reference rate. (3) The start and end date for each calendar year have been adjusted to the dates when data for both
above indices and Gold (INR) price are available for a particular date. (4) Source: LBMA, RBI & MFI Explorer. (5) * For the
period Jan 09 to Nov 09.
The Solution
Asset
Allocation
A powerful approach to long-term
investment success
What Is Asset Allocation?
• The methodology of creating diversified

portfolios by making allocations to a
number of distinct asset classes
• The goal of a good asset allocation is to

develop a portfolio that will help you reach
your financial goals with the degree of risk
that is acceptable to you.
Asset Classes – Risk-Return
Profile
Indian Equity
Return
Gold
International Equity
Debt
Cash
2002-09
Risk
Different asset classes have different levels of risk attached and returns expectations
Risk measured as standard deviation of returns
Asset classes – Variation in Returns
Range of 1 year returns (2002-2009)
Maximum
Average
Minimum
Risky asset classes have higher variations in returns

Why does it work?
• Asset classes vary based on

– Reaction to macro-economic environment
– Growth/ recession
– Inflation/ deflation
– High/ low interest rates
– Correlations
– Volatility
– Risk of capital loss
Non correlated assets add value to the portfolio

Asset Classes – Correlations
Asset allocation portfolios benefit from lower correlations across asset classes
2002-2009
International
Debt Cash Gold
Equities
Indian Equities 10% 74% -29% 4%
Debt 4% 31% 1%
International
-46% 11%
equities
Gold -3%
Mean variance optimization theory
• The fundamental goal of portfolio theory is to optimally allocate your investments between
different assets.
• Mean variance optimization (MVO) is a quantitative tool which will allow you to make this
allocation by considering the trade-off between risk and return
• Consider an example where we construct a portfolio with 2 assets :
Correlation matrix
Standar
Expect
d
ed
Asset deviatio Asset 1 Asset 2
return
n
Asset 1 10.0% 10.0% 1.0 -1.0

Asset 2 13.0% 30.0% -1.0 1.0
• We construct 5 portfolios with the 2 Assets

– Portfolio A : 100% allocation to Asset 1
– Portfolio B : 75% Asset 1, 25% Asset 2
– Portfolio C : 50% Asset 1, 50% Asset 2
– Portfolio D : 25% Asset 1, 75% Asset 2
– Portfolio E : 100% allocation to Asset 2
Returns of Portfolio B & C are higher than Portfolio A with risk <= Portfolio A
Efficient Portfolio Construction
• Identify asset classes and

determine expected return,
risk, and correlation
among them
• Use optimization model to
identify efficient
combinations of assets
• Optimization is the process
of identifying portfolios that
have the highest possible
expected return for a given
risk level
• Such a portfolio is
considered “efficient,” and
the locus of all efficient
portfolios is called the
efficient frontier
Asset Allocation Effect
Indian Equity
ER Gold
Return I
O NT Aggressive
FR International Equity
E NT
I Moderate
F IC
EF
Conservative
Debt
Cash
Risk
Efficient frontier ensures improvement in returns for the same quantity of risk taken
Risk measured as standard deviation of returns

Asset Allocation Effect … cont’d
Maximum
Investors can focus on risk-return

rather than market movements
Average
Minimum
Asset Allocation allows investors to target a risk-level based on their situation

How Asset Allocation is used
Asset Allocation strategy using NIFTY, Gold and Liquid Asset classes
Benefits of asset allocation
• Benefits from low correlations amongst asset classes over a
business cycle
• Helps smoothen out portfolio volatility
• Helps focus on portfolio risk levels rather than market levels
• Thus, asset allocation has the following advantages if used

prudently
– Reduces risk
– Improves returns for every unit of risk taken
– Helps focus on long-term objectives
Asset Allocation & Diversification – The Most Important
Decision is Setting the Strategic Asset Allocation…
82% of the portfolio performance is determined by the

strategy – not the selection of specific securities!
Other Selection
Selection 4%
6%
Timing
8%
Strategy
Strategy
82%
Source: Financial Analysts Journal 1986, 1991, 1995, 2002: Gary Brinson, Brian Singer and Gilbert Beebower. Determinants of Portfolio Performance
Study included 91 Pension Funds over a 10 year time horizon
Asset Allocation – Risk Profile
Client Risk Profile Portfolio Risk
Risk Profile Risk Measures

• Standard Deviation
Risk Ability Standard deviation shows how much variation there
is from the "average" (mean, or expected/budgeted
Risk Profile value). A low standard deviation indicates that the
data points tend to be very close to the mean,
Risk Tolerance whereas high standard deviation indicates that the
data is spread out over a large range of values.
Risk Profile Determinants • Value at Risk (VAR)

• Client’s Financial Position
Value-at-risk (VaR) is a category of risk metrics that
describe probabilistically the market risk of a trading
• Dependence on Investment Returns portfolio. Value-at-risk uses historical volatility to
track the market risk of a portfolio.
• Clients’ Investment Experience
For example, if a portfolio of INR 10 Million has 1 yr
• Interest 95% VaR of Rs. 500,000, it implies that assuming
normal conditions, it is 95% probable that the yearly
• Comfort & Risk Orientation loss in the underlying portfolio will not exeed Rs.
500,000
Allocation process
Risk Budget (Client's Risk Profile):

Allocated Risk (Portfolio Risk): -
Desired Return on Investments:

Expected Portfolio Return 0.0%
Asset Allocation
Asset Class Allocation Hist. Returns Hist. Risk Return Risk
Cash 5.0% 1
Fixed Income 8.0% 2
Equities 20.0% 5
Alternative Investments 15.0% 4
Total 0.0% 0.0% -

Standard Investment Profiles
Risk Profile Investment Strategy Strategy
Low
Moderate
Medium
Enhanced
High
Objectives
•The proposed strategy is derived directly from client's risk profile (risk ability & tolerance)
•If appropriate, a different selected strategy can be applied to achieve identified
needs/objectives – need to document reason for deviation
•Set a basis for continuous monitoring of client's portfolios and proactive advice
In Conclusion …
• Asset Allocation has the following

advantages
– Reduces risk
– Improves returns for every unit of risk

taken
– Helps focus on long-term objectives

Thank you
Annexures …
Annexures …
Thank you

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Asset Allocation

“A powerful approach to long-term investment success”

• Steep losses in short-term can derail the long-term

• It is Impossible to predict market moves

• The methodology of creating diversified

• The goal of a good asset allocation is to

Risky asset classes have higher variations in returns

• Asset classes vary based on

Non correlated assets add value to the portfolio

Asset 1 10.0% 10.0% 1.0 -1.0

• We construct 5 portfolios with the 2 Assets

• Identify asset classes and

Risk measured as standard deviation of returns

Investors can focus on risk-return

Asset Allocation allows investors to target a risk-level based on their situation

• Helps smoothen out portfolio volatility

• Helps focus on portfolio risk levels rather than market levels

• Thus, asset allocation has the following advantages if used

82% of the portfolio performance is determined by the

Client Risk Profile Portfolio Risk

Risk Profile Risk Measures

Risk Profile Determinants • Value at Risk (VAR)

Risk Budget (Client's Risk Profile):

Desired Return on Investments:

Total 0.0% 0.0% -

Risk Profile Investment Strategy Strategy

• Asset Allocation has the following

– Improves returns for every unit of risk

– Helps focus on long-term objectives

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