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Asset Allocation in PMS
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Determining the optimum mix of assets to get desired rate of returns is the primary purpose of investing in a PMS. Therefore, asset allocation becomes one of the most important facets.

But does every investor want to invest in similar assets/stocks? No.

Factors that govern the asset allocation of a portfolio:

  1. Objective
  2. Time Horizon
  3. Risk

Objective : Every investor has varied interests and needs; consequently their financial goals/ objectives differ.  What kind of securities or stocks does the investor want to invest in? What kind of returns the investor looking for? Does the investor want his portfolio to be managed actively or passively? Does the investor want an aggressive portfolio for high returns or a conservative one to safeguard his principle? These questions are answered through a questionnaire or risk profile which is filled by investor when he/she enters in a scheme which subsequently determines the asset mix in the portfolio.

Time Horizon : It is the time duration for which the investor wants to invest his money in a PMS scheme before it gets liquidated. It depends on the availability and requirement of funds by the investor, as when does he require the funds in future, or does he have enough to keep it invested for longer periods of time? It is also dependent on the age of investor or time remaining for his/her retirement. Usually the investments for less than 3 years are considered as Short Horizon and the ones for longer than 5-8 years are called Long Horizon.

Risk Appetite : It is one of the most important factors in determining the asset mix, as risk is directly related to return. Hence, higher the investment risk, higher the return. An aggressive portfolio is generally risky as it yields high returns. Similarly a conservative portfolio will yield lower returns than an aggressive one. Diversification is often used to decrease the volatility in the portfolio.

Examples of Asset Allocation Strategies:

Sector Specific Strategy : This is a strategy that is followed by investors who are predominantly interested in following single sector. It is a high risk strategy as there is less scope for diversification. Subsequently, the exposure is high in one sector only as the stocks are concentrated. The performance of the portfolio will be in congruence with the growth of the sector. It is usually followed by investors looking for aggressive portfolio. It is suitable for longer time horizons as returns are realized over years following business cycles. There may be various reasons for an investor to adopt this strategy which include investment goals, interest in particular sector, dividends (some sector companies provide good dividend income) or other financial reasons (for example: some stocks perform well when the interest rates are high, on the contrary some perform well when the interest rates are low). It is similar to a passively managed portfolio.

Sector Rotation Strategy :  This strategy is based on the business cycle of stocks. The investor overweight’s the proportion of portfolio with stocks from sector that is experiencing favorable market conditions currently, and underweights with other stocks. After a while, other sectors might perform better than others, and it may be the time for the fund manager to review and revise the stocks. This strategy is used to outperform the market by reducing exposure in high risk stocks.

Diversification Strategy : It is one of the most popular approaches that are followed in asset allocation. Mitigation of risk is the prime reason to diversify; unlike sector specific approaches, where single sector exposure increases risk. Although investors may lean towards an aggressive/conservative portfolio based on their risk potential and financial goals while keeping it diversified to certain extent. A multi-cap portfolio is a good example of diversified portfolio, wherein investor picks up various stocks from the large cap (to reduce risk), mid cap and small cap(for high growth potential).

From the above we can infer that Asset Allocation is the most determinant stage in Portfolio Management, as Risk and Return is a consequence of the same.

 

Earlier blogs in the PMS series:

Introduction to Portfolio Management Services Click here 

Charges in PMS Click here


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