Risk Profiling and Asset Allocation
What is risk profile?
Risk profiling is an evaluation of an individual’s willingness and ability to take risks.. A risk profile is important for determining a proper investment asset allocation for a portfolio.
To understand and determine an appropriate asset allocation, two essential approaches are taken into consideration – strategic and tactical asset allocation.
What is Asset Allocation?
It's more of a strategy than a process. It establishes a framework for an investor’s portfolio by properly aligning their asset mix with their long-term investment goals and objectives. Countless studies support the thought that investor’s asset allocation is the primary driver of portfolio returns. Maintaining an appropriate strategic asset allocation is what keeps investors pointed in the right direction for the long term.
It's of extreme importance to stick to the original allocation (unless there is an exceptional or critical scenario) over a long period of time, typically spanning over a decade or more. Such a long-term strategic approach helps investors avoid making short-term, emotional decisions based on current market trends.
How does strategic asset allocation work?
This strategy requires establishing allocation targets for each portfolio components (stock, bonds, and other such asset classes). Key investor-specific inputs include risk tolerance, investment goals, and time horizon for investing. The process also requires an understanding of expected returns, volatility and correlations of each asset class or portfolio component.
Once strategic allocation targets are established, rebalancing portfolio investment with those target levels is an integral part of the process. This rebalancing process can be implemented periodically, such as quarterly, half yearly, or even annually. Another method is to rebalance the portfolio assets once a certain threshold or tolerance level has been breached..
How important is Tactical Asset Allocation?
Tactical asset allocation involves establishing a baseline mix of assets that are suitable for an investor’s risk tolerance and investment objectives. However, instead of simply deciding on investor’s asset mix and sticking to it, a tactical investor will actively adjust the portfolio weightings based on short- and medium-term expectations for economic conditions, valuations, market cycles, etc. These tactical asset allocation changes or shifts are implemented with the goal of generating superior risk-adjusted returns compared to a strategic asset allocation approach.
Tactical asset allocation amplifies potentiality of the return, lowers the potential portfolio risk and emphasises on the diversification.
How does Tactical asset allocation work?
This approach works by actively shifting the portfolio allocations to take advantage of market trends, economic conditions and/or perceived misplaced opportunities in asset classes or investments.
Understanding Portfolio Weight
What does Portfolio Weight mean?
Portfolio Weight can be defined as a percentage that defines how much a particular asset or a group of assets makes up of the total portfolio investment made.
One must remember that the weight of an asset will fluctuate if the asset is a stock or a stock fund, as the market constantly fluctuates – thus affecting not only the particular asset in consideration, but also the entire portfolio. Hence, periodic adjustments of such weights are essential to make sure that the portfolio weight in total and of an asset – reflects a true picture.
A portfolio, at its very base, is created with weights in mind. Each asset that makes up a part of the total portfolio is given a specific weight. This weight is usually allocated by the asset type. For example, in a portfolio – a blue chip investment shall make up of 40% while bonds shall only be 20% and the rest could equally be divided between aggressive stocks and other stock funds.
Base of portfolio weights
It is important to understand the base by which an asset is allocated its weight. The base must stay constant, i.e., if the assets in a portfolio are allocated weights as per the industry or sectors to which these assets belong to, then they should be allocated as per the same guidelines for any future period. This allows comparison and understanding of growth and trends of a portfolio’s performance.
Approaches to Weight Allocation
There are largely three common ways to allocate weights to a portfolio.
The basic method is to determine the weight of an individual asset by dividing the dollar value of a security by the total dollar value of the portfolio. This is the simplest of all weights.
The second method requires us to divide the number of units of a given security by the total number of shares held in the portfolio.
The last method observes investors calculating the weights of their portfolios in terms of sector, geographical region, index exposure, short and long positions, type of security, such as bonds or small-cap technology, or any other factor they may find relevant.
The choice of portfolio weights would depend upon the overall investment strategy.
What is imperative is a constant revisiting of these weights when the underlying assets are market linked. Market price changes would warrant a dynamic rebalancing of corresponding weights in line with the overall asset allocation and investment strategy.
5 R Portfolio Performance Approach
Portfolio Performance refers to the performance of an investor’s portfolio during a stipulated period. This period is usually considered to be the current fiscal year. Understanding the performance is essential not just for investors to know how much of returns did they gain or lose, but to also understand the effect of their investing decision upon varied allocated assets in their portfolio. The performance of the portfolio helps in understanding the effects of past investment decisions, reflects the current market trend effects and helps in analysing as well as formulating the future course of investment strategy for that specific allocated asset and portfolio.
Taking absolute returns generated by the portfolio as the sole yardstick to measuring portfolio performance could be grossly misleading. The performance of the portfolio should always be measured in the context of asset class mix, the commensurate risk and relevant benchmarks following the 5 R approach. This approach takes into account 5 critical ratios that measure the risk adjusted return of an investment portfolio.
- Sharpe Ratio: (Expected Return–Risk Free Return/Portfolio Standard Deviation)
- Roy’s Saftey First Ratio: (Expected Return–Target Return/Portfolio Standard Deviation)
- Sortino Ratio: (Expected Return–Target Return/Portfolio Downside Standard Deviation)
- Treynor Ratio: (Expected Return–Risk Free Return/Portfolio Beta)
- Information Ratio: (Portfolio Return – Benchmark Return/ Tracking Error)
It is always helpful to be hands-on when it comes to understanding, the execution then becomes easy to delegate. As a client, one should catch on to the first hand granular information that’s explainable through different scenarios. It will become easier to comprehend the logic and model attached to it which will naturally lead to a frequency alignment between you and your advisor.