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Nmims Project Sep-21

Corporate finance (SVKM's NMIMS)

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A PROJECT REPORT ON

FINANCIAL PLANNING THROUGH

ASSET ALLOCATION

SUBMITTED BY
CLINT D’MELLO
Student No: 77119681800

IN PARTIAL FULFILMENT OF POST GRADUATE DIPLOMA IN

BUSINESS MANAGEMENT (FINANCE)
(2019-2021)

SVKM’s NMIMS Deemed-to-be University

V. L. Mehta Road, Vile Parle (W) Mumbai, Maharashtra - 400056

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Declaration

I, Clint D’mello, student of SVKM’s NMIMS Deemed-to-be University hereby declare

that this project report titled <Financial Planning through Asset Allocation= carried out
under the guidance of my professors is the record of authentic work carried out by me.

Date: 28-08-2021

Clint D’mello Academic Guide

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Acknowledgement

It is indeed a matter of great pleasure, proud and privilege to be able to submit

this project on <Financial Planning through Asset Allocation=. The
satisfaction and euphoria that accompany the successful completion of any
task is incomplete without the mention of people who made it possible. So, I
take this as a great opportunity to pen down a few lines about people to whom
my acknowledgement is due.

It is with the deepest sense of gratitude that I wish to place on my sincere

thanks to my project guide and my professors for providing me inspiration,
encouragement, guidance, help and valuable suggestions throughout the
project. It is due to his enduring efforts, patience & enthusiasm that has given
a sense of direction to this project & ultimately made it a success.

My special gratitude to my college Narsee Monjee Institute of Management

Studies for their constant guidance and motivation for completing this work to
my best possible ability. Finally I would like to render my sincere thanks to
my family and friends for their support and best wishes throughout the project.

Clint D’mello

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INDEX

Sr No Pg. No
Title

1 Executive Summary 5

2 Introduction 6

3 Financial Planning 7

4 Asset Allocation 11

5 Rule of Thumb 27

6 Questionnaire 29

7 Conclusions 31

8 Bibliography 32

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EXECUTIVE SUMMARY

An investment is a sacrifice of current money or other resources for future benefits.

Numerous avenues of investment are available today. The two key aspects of any
investment are time and risk. Very broadly, the investment process consists of two tasks.
The first task is security analysis which focuses on assessing the risk and return
characteristics of the available investment alternatives. The second task is portfolio
selection which involves choosing the best possible portfolio from the set of feasible
portfolios.

Construction of portfolio is only part of the battle. Once it is built, the portfolio needs to
be maintained. The market values, needs of the beneficiary, and relative merits of the
portfolio components can change over time. The individual must react to these changes.
Asset Allocation usually requires periodic revision of the portfolio in accordance with a
predetermined strategy.

The type of sampling technique used is Simple Random Sampling wherein a

questionnaire was prepared and distributed to the retail investors. The investor’s profile is
based on the results of a questionnaire that the Investors completed. The Sample consists
of 50 retail investors from various backgrounds. The target customers were only the retail
investors who invest in various avenues to know about their knowledge and concern
regarding the economy, principal invested, investment options, market conditions etc

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INTRODUCTION

2 ABOUT BOMBAY STOCK EXCHANGE BROKER’S FORUM:

2.1 Introduction:

The Bombay Stock Exchange Brokers Forum (BBF), a not-for-profit body registered
under the Societies Act 1860, consisting of around 900 members being members of Stock
Exchanges (BSE/NSE), Commodity Exchanges (MCX, NCDEX) and Depository
Participants of Depositories (CDSL/ NSDL). The Capital Market intermediaries are a
heterogeneous group, where on one hand we have the small mom and pop shop type
organizations and at the other end of the spectrum large institutions like banks. BBF
attempts to work for the benefit of the Capital Markets in general and its members in
particular.

2.2 Objective:
The BSE Brokers’ Forum has since 1993 been striving for the development of the
financial markets in general and its members in particular. The objective of the FORUM
is to highlight the concerns of the member brokers to Regulators and Exchanges. The
FORUM main sphere of activities includes:
1. Representation to Regulators
2. Seminars for member brokers
3. Investor Awareness program
4. Global Connect Tour
5. Handling Member Grievances

2.3 Compliance:

Compliance with the law is the basic regulatory expectation by the authorities from its
citizens. As an association, we believe that the majority of our members are law abiding.
However, whenever a new requirement is envisaged, the market participants are faced
with the twin issues of

. Understanding the new law

. Consequent changes in their systems and processes
The matters are further compounded by the lack of availability of sufficient
professionals conversant with the matter to guide the market participants. At times,
the costs of the professionals are prohibitive for a majority of small and medium
enterprise

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FINANCIAL PLANNING

3.1. What is Financial Planning?

Financial planning is a process of setting objectives, assessing assets and resources,
estimating future financial needs, and making plans to achieve monetary goals. Many
elements may be involved in this process, including investing, asset allocation, and risk
management. Tax, retirement, and estate planning are typically included as well.
Financial planning plays a starring role in helping individuals get the most out of their
money. Careful planning can help individuals and couples set priorities and work steadily
towards long-term goals. It may also provide protection against the unexpected, by helping
individuals prepare for things such as unexpected illness or loss of income.

Financial planning may mean different things to different people. For one person, it may
mean planning investments to provide security during retirement. For another, it may mean
planning savings and investments to provide money for a dependent's college education. It
may even involve making career-related decisions or choosing the right insurance products.

Many individuals choose to use the services of financial planners to help them reach their
goals. A financial planner is a professional who provides advice and guidance for a wide
spectrum of financial planning issues. Financial planners may or may not be certified and
offer varied levels of experience.
Though a financial planner may make developing a financial plan easier, hiring one is not at
all a necessity. There are many books, computer programs, and other resources available to
help individuals with financial planning. Furthermore, there is a wealth of related information
available on the Internet. The decision to hire a financial planner may depend on many
things, including the financial worth of the individual, his or her goals for the future, and the
amount of research the individual is willing to perform.

All too often, people delay planning for the future. They may feel such planning should take a
back seat to staying financially afloat in the present. However, even those living from pay
check to pay check can benefit from financial planning by creating a budget. A budget can be
used to determine what is actually spent each month and find ways to trim or even eliminate
unnecessary or out-of-control expenditures. The right time to create a financial plan is right
now. No matter what your income level or what your hopes for the future, you need a solid
plan to achieve your goals. Drifting through life without carefully set goals and well-
researched methods of achieving them is a recipe for disaster. To enable your money to offer
you more of what you want out of life, start creating a financial plan today. It has got many
objectives to look forward to:

➢ Determining capital requirements- This will depend upon factors like cost of
current and fixed assets, promotional expenses and long- range planning. Capital
requirements have to be looked with both aspects: short- term and long- term
requirements.

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➢ Determining capital structure- The capital structure is the composition of capital,

i.e., the relative kind and proportion of capital required in the business. This includes
decisions of debt- equity ratio- both short-term and long- term.
➢ Framing financial policies with regards to cash control, lending, borrowings, etc.
➢ A finance manager ensures that the scarce financial resources are maximally
utilized in the best possible manner at least cost in order to get maximum returns on
investment.

3.2. Why Financial Planning is important?

Financial Planning is process of framing objectives, policies, procedures, programmes and

budgets regarding the financial activities of a concern. This ensures effective and adequate
financial and investment policies. The importance can be outlined as-

• Adequate funds have to be ensured.

• Financial Planning helps in ensuring a reasonable balance between outflow and
inflow of funds so that stability is maintained.
• Financial Planning ensures that the suppliers of funds are easily investing in
companies which exercise financial planning.
• Financial Planning helps in making growth and expansion programmes which helps in
long-run survival of the company.
• Financial Planning reduces uncertainties with regards to changing market trends
which can be faced easily through enough funds.
• Financial Planning helps in reducing the uncertainties which can be a hindrance to
growth of the company. This helps in ensuring stability and profitability in concern.

➢ Finance Functions

The following explanation will help in understanding each finance function in detail

➢ Investment Decision

One of the most important finance functions is to intelligently allocate capital to long term
assets. This activity is also known as capital budgeting. It is important to allocate capital in
those long-term assets so as to get maximum yield in future. Following are the two aspects of
investment decision

a. Evaluation of new investment in terms of profitability

b. Comparison of cut off rate against new investment and prevailing investment.

Since the future is uncertain therefore there are difficulties in calculation of expected return.
Along with uncertainty comes the risk factor which has to be taken into consideration. This
risk factor plays a very significant role in calculating the expected return of the prospective

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investment. Therefore, while considering investment proposal it is important to take into

consideration both expected return and the risk involved.

Investment decision not only involves allocating capital to long term assets but also involves
decisions of using funds which are obtained by selling those assets which become less
profitable and less productive. It wise decisions to decompose depreciated assets which are
not adding value and utilize those funds in securing other beneficial assets. An opportunity
cost of capital needs to be calculating while dissolving such assets. The correct cut off rate is
calculated by using this opportunity cost of the required rate of return (RRR)

➢ Financial Decision

Financial decision is yet another important function which a financial manger must perform.
It is important to make wise decisions about when, where and how should a business acquire
funds. Funds can be acquired through many ways and channels. Broadly speaking a correct
ratio of an equity and debt has to be maintained. This mix of equity capital and debt is known
as a firm’s capital structure.

A firm tends to benefit most when the market value of a company’s share maximizes this not
only is a sign of growth for the firm but also maximizes shareholders wealth. On the other
hand the use of debt affects the risk and return of a shareholder. It is more risky though it may
increase the return on equity funds.

A sound financial structure is said to be one which aims at maximizing shareholders return
with minimum risk. In such a scenario the market value of the firm will maximize and hence
an optimum capital structure would be achieved. Other than equity and debt there are several
other tools which are used in deciding a firm capital structure.

➢ Dividend Decision

Earning profit or a positive return is a common aim of all the businesses. But the key function
a financial manger performs in case of profitability is to decide whether to distribute all the
profits to the shareholder or retain all the profits or distribute part of the profits to the
shareholder and retain the other half in the business.

It’s the financial manager’s responsibility to decide an optimum dividend policy which
maximizes the market value of the firm. Hence an optimum dividend payout ratio is
calculated. It is a common practice to pay regular dividends in case of profitability Another
way is to issue bonus shares to existing shareholders.

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➢ Liquidity Decision

It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s

profitability, liquidity and risk all are associated with the investment in current assets. In
order to maintain a trade-off between profitability and liquidity it is important to invest
sufficient funds in current assets. But since current assets do not earn anything for business
therefore a proper calculation must be done before investing in current assets.

Current assets should properly be valued and disposed of from time to time once they become
non-profitable. Currents assets must be used in times of liquidity problems and times of
insolvency.

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ASSET ALLOCATION
4.1. What is Asset Allocation?

Asset allocation is an investment portfolio technique that aims to balance risk by dividing
assets among major categories such as cash, bonds, stocks, real estate, and derivatives. Each
asset class has different levels of return and risk, so each will behave differently over time.
For instance, while one asset category increases in value, another may be decreasing or not
increasing as much. Some critics see this balance as a recipe for mediocre returns, but for
most investors, it's the best protection against a major loss should things ever go amiss in one
investment class or sub-class.

The consensus among most financial professionals is that asset allocation is one of the most
important decisions that investors make. In other words, your selection of stocks or bonds is
secondary to the way you allocate your assets to high and low-risk stocks, to short and long-
term bonds, and to cash.

There is no simple formula that can find the right asset allocation for every individual 3 if
there were, we certainly wouldn't be able to explain it in one article. We can, however,
outline five points that we feel are important when thinking about asset allocation:

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1. Risk vs. Return

The risk-return trade-off is at the core of what asset allocation is all about. It's easy for
everyone to say that they want the highest possible return, but simply choosing the assets
with the highest "potential" (stocks and derivatives) isn't the answer.

The crashes of 1929, 1981, 1987 and the more recent declines of 2007-2009 are all examples
of times when investing in only stocks with the highest potential return was not the most
prudent plan of action. It's time to face the truth: Every year your returns are going to be
beaten by another investor, mutual fund, pension plan, etc. What separates greedy and return-
hungry investors from successful ones is the ability to weigh the relationship between risk
and return.

Yes, investors with a higher risk tolerance should allocate more money into stocks. But if you
can't remain invested through the short-term fluctuations of a bear market, you should cut
your exposure to equities.

2. Don't Rely Solely on Financial Software or Planner Sheets

Financial-planning software and survey sheets designed by financial advisors or investment

firms can be beneficial, but never rely solely on software or some pre-determined plan. For
example, one old rule of thumb that some advisors use to determine the proportion a person
should allocate to stocks is to subtract the person's age from 100. In other words, if you're 35,
you should put 65% of your money into stocks and the remaining 35% into bonds, real estate,
and cash. More recent advice has shifted to 110 or even 120 minus your age.

But standard worksheets sometimes don't consider other important information such as
whether or not you are a parent, retiree or spouse. Other times, these worksheets are based on
a set of simple questions that don't capture your financial goals.

Remember, financial institutions love to peg you into a standard plan not because it's best for
you, but because it's easy for them. Rules of thumb and planner sheets can give people a
rough guideline, but don't get boxed into what they tell you.

3. Determine Your Long- and Short-Term Goals

We all have our goals. Whether you aspire to build a fat retirement fund, own a yacht or
vacation home, pay for your child's education or simply save for a new car, you should
consider it in your asset-allocation plan. All these goals need to be considered when
determining the right mix.

For example, if you're planning to own a retirement condo on the beach in 20 years, you don't
have to worry about short-term fluctuations in the stock market. But if you have a child who
will be entering college in five to six years, you may need to tilt your asset allocation to safer

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fixed-income investments. And as you approach retirement, you may want to shift to a higher
proportion of fixed-income investments to equity holdings.

4. Time Is Your Best Friend

The U.S. Department of Labour has said that for every ten years you delay saving for
retirement (or some other long-term goal), you will have to save three times as much each
month to catch up.

Having time not only allows you to take advantage of compounding and the time value of
money, but it also means you can put more of your portfolio into higher risk/return
investments, namely stocks. A couple of bad years in the stock market will likely show up as
nothing more than an insignificant blip 30 years from now.

5. Just Do It!

Once you've determined the right mix of stocks, bonds, and other investments, it's time to
implement it. The first step is to find out how your current portfolio breaks down.

It's fairly straightforward to see the percentage of assets in stocks versus bonds, but don't
forget to categorize what type of stocks you own (small, mid or large cap). You should also
categorize your bonds according to their maturity (short, mid or long-term).

Mutual funds can be more problematic. Fund names don't always tell the entire story. You
have to dig deeper in the prospectus to figure out where fund assets are invested.

6. The Bottom Line

There is no single solution for allocating your assets. Individual investors require individual
solutions. Furthermore, if a long-term horizon is something you don't have, don't worry. It's
never too late to get started.

It's also never too late to give your existing portfolio a face-lift. Asset allocation is not a one-
time event, it's a life-long process of progression and fine-tuning.

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4.2. Risk and Return: -

A grasp of the statistical meaning of return and risk. You are ready to tackle the long-term
historical record of a wide range of assets. Presumably, you would not purchase a car or
refrigerator without checking its performance and repair record in a suitable publication like
Consumer Reports. In a similar fashion, you should not commit a sizable portion of your
disposable income to an investment without a good idea of its expected return (performance)
and risk (repair record) Fortunately, there is a large amount of useful data out there waiting
for you, and it is easily accessible and cheap. it takes at least 20 or 30 years of data are
necessary to get a good idea of expected return. You can get a good idea of asset risk by
looking at monthly data for not much more than 5 or 10 years.

One of the great bargains in the investing world is the Ibbotson monograph, Stocks, Bonds,
Bills, and Inflation (known in the investing world as <the SBBI=). This contains every
possible breakdown for returns, risks, and correlations of many U.S. assets for periods
ranging from a month to decades. We shall consider five assets: large and small U.S. stocks,
and 30-day, 5year, and 20-year Treasury securities. Summarizes what you really need to
know about U.S. stocks and bonds in the aggregate it would not be a bad idea to commit the
approximate return and SD figures for these five assets to memory.

Reviewing each asset individually. You should refer to the accompanying series of graphs for
each asset. The terminology for government securities is confusing. A security of less than 1
year is called a Treasury bill, or more simply, a T-bill. An obligation of 1 to 10 years is
called a note, and of greater than 10years a bond. The famous financial analyst Benjamin
Graham once said that in the short run the stock market is a voting machine, but that in the
long run it is a weighing machine. What it weighs are earnings. In these ebullient times, the
torpid and occasionally stuttering growth of common stock earnings cannot be stressed
strongly enough. For this reason, I’ve plotted the earnings of the Dow Jones Industrial
Average from 1920.Some of the main pointers that is taken into consideration are:

1. Risk and reward are inextricably intertwined. Do not expect high returns without high
risk. Do not expect safety without correspondingly low returns.

2. The longer a risky asset is held, the less the chance of a poor result.

3. The risk of an asset or a portfolio can be measured. The easiest way to do this is by
calculating the standard deviation of returns for many time periods.

4. Those who are ignorant of investment history are bound to repeat its mistakes.
Historical investment returns and risks of various asset classes should be studied. Investment
results for an asset over a long enough period (greater than 20 years) are a good guide to the
future returns and risks of that asset. Further, it should be possible to approximate the future

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long-term return and risk of a portfolio consisting of such assets. Some of the investment
class are:-

➢ Treasury Bills.

A Treasury bill (see Figure 2-1) is the safest investment on earth. Short of national
destruction, there is no possibility of default, although Uncle Sam occasionally prints money
to make good. The price paid for this safety is steep; the return is only 3.77%, which is
barely above the inflation rate of 3.08% for the 19263 1998 period. Further, although many
academicians consider T-bills to be <riskless,= a quick perusal of the T-bill graph shows
considerable variation of return, meaning that you cannot depend on a constant income
stream. This risk is properly reflectedin the SD of 3.22%. The best that can be said for the
performance of T-bills is that they keep pace with inflation in the long run, although there
were prolonged periods when even this was not true, particularly in the 1970s.

➢ Treasury Notes.

Like T-bills, intermediate-term (5year) Treasury notes offer near absolute protection from
default on principal and inter est. but do carry one risk that of rising interest rates. A note or
bond yielding a fixed coupon will decline in market value when interest rates rise, and the
longer the maturity of the note or bond the worse the damage. At a maturity of five years, the
loss in principal market value can exceed the coupon of the note or bond, resulting in a
negative total return for the year. This has happened seven times in the past 73 years, and,
in fact, the worst loss for this period (2.65%) occurred in 1994. For bearing this risk, you are
rewarded with another 1.5% of long-term return. In the long run, the real (inflation-adjusted)
return was about 2%.

➢ Treasury Bonds

Long-Term (20-Year) Treasury Bonds. Long-term Treasuries behave in much the same way
as the intermediate notes, except that their interest rate risk is much worse, producing losses
in 20 of the past 73 years, with one loss of nearly 10%, and many losses in excess of 5%
Surprisingly, you do not seem to be rewarded at all for bearing this risk; the return is almost
identical to that of five-year notes.

➢ Large Company Stocks

Large Company Common Stocks. For the past 73 years, this asset class has consisted of
various groups of large companies, or <indexes.= The latest incarnation is the familiar S&P
500. The reader may find the terminology of this group confusing. They are referred to
variously as <large stocks,= <the S&P,= or <the S&P 500.= For the purposes of this book,
all of these terms are interchangeable. The rewards of this asset are considerable: a real
return of greater than 8%. The lure of common stocks is undeniable your inflation-adjusted
wealth will double every nine years. Put away $10,000 for your new-born child, and in 50
years he or she will have $470,000 of current spending power for your grandkids’ college
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educations. This return does not come free, of course. The risks can be stomach-turning. The
SD for large company common stocks is 20.26%. (This is the number behind Uncle Fred’s
coin toss its SD is also 20%.) You can lose more than 40% in a bad year, and during the four
calendar years 192931932 the inflation adjusted (<real=) value of this investment class
decreased by almost two-thirds!

➢ Small Company Stocks

Companies whose total outstanding stock value, or <market cap,= places them in the bottom
20% of the New York Stock Exchange by size are considered small company stocks. (In the
current era most of these stocks are actually traded over the counter.) Here, the returns and
risks are industrial grade. Your real return is now greater than 9%, meaning that you will
double your money in inflation-adjusted terms in just eight years. Put away $10,000 for your
grandkids and you will have $785,000 in 50 years in current spending power. But oh, the
risks: for 192931932 this investment class lost over 85%. Small stock returns, 192631998.
The effects of longer holding periods for large company U.S. stocks. Rolling five-year returns
for large stocks; except for the Great Depression, things do not look so scary, with only a few
losing periods. There is not a single 30-year period with a return of less than 8%! The
message is clear: stocks are to be held for the long term. Don’t worry too much about the
short-term volatility of the markets; in the long run, stocks will almost always have higher
returns than bonds.

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4.3. How should you go about asset allocation?

First determine your risk appetite, financial goals and time horizon. If you have an aggressive
risk profile, you may invest about 60% to 70% of your entire portfolio into equity-oriented
investments like Mutual Funds provided you have time by your side and spread the rest in
debt instruments and cash holdings for liquidity and contingency purposes. Here, you may
like to read Mutual Funds that you must have in your portfolio
A moderate risk taker with a balanced risk appetite should invest about 35% - 40% of his
money in equity-oriented investments like Mutual Funds and the rest in debt and real estate
with about 5-10% in cash. On the other side, a conservative investor can have a minimal 15%
- 20% equity exposure, 50% - 60% in debt and liquid funds with around 20-30% in alternate
investments. Choosing the apt portfolio is the first and the most important step towards an
informed financial planning which would best suit your requirements along with your
financial goals and risk appetite.

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4.4. Optimum Asset Allocation

When we say <optimal allocations.= We can be talking about one of three allocations: future,
hypothetical, or historical. You cannot know future optimal portfolio composition any more
than you can sprout wings and fly, play point guard for the Lakers, or win the Miss America
pageant. Anybody who tells you that they know the optimal future allocation belongs in Sing-
Sing or Bellevue. (And were you able to do this, you sure-as-shooting’ wouldn’t need this
book. You would know the future returns of all asset classes, and you wouldn’t need asset
allocation. What you would in fact need is a competent pilot for your Gulfstream V to get you
back and forth between your villas in Davos, Palm Springs, Jackson Hole, and Martha’s
Vineyard. Allocations are of three types;-

➢ Hypothetical optimal allocation refers to the process of postulating a set of returns,

SDs, and correlations and then calculating the optimal allocations for these inputs.
➢ Historical optimal allocation, what was optimal in the past, can be calculated. This
is an interesting exercise, and one that we shall shortly engage in, but it is a very poor
way to determine future allocations. We’ve already hinted at one method for
calculating historical optimal allocations.

It is not that difficult to spreadsheet the historical returns and fiddle with your allocations
until you are no longer able to improve portfolio return versus risk. In fact, most spreadsheets
contain an optimizer tool that will allow you to determine the portfolios which will give you
the most (or even least!) return at a given SD level, or the least SD at a given level of return.
This is a sort of <poor man’s optimizer.= However, both of these methods are quite slow and
cumbersome and are not appropriate for the serious student of portfolio theory. For one thing,
it is an enormous amount of work to do <what if= analyses of what happens with variations of
an asset’s return or SD, and almost impossible to change its correlation with other assets.
There is a much faster and easier way to optimize portfolios4mean-variance analysis,
devised several decades ago by Harry Markowitz (and for which he earned a Nobel Prize). A
software application which uses this method is called a mean-variance optimizer (MVO). An
MVO will rapidly compute optimal portfolio compositions from three sets of data. These are:

1. The return for each asset.

2. The standard deviation of each asset.

3. The correlations among all the assets.

MVO Plus has the unique ability to identify the portfolio with the maximum annualized
(geometric) return, whereas all other commercially available optimizers will identify the asset
with the highest arithmetic return as the last portfolio, which is not the one with the highest
geometric return. This is because the difference between the arithmetic and geometric returns
is approximately half its variance, or (SD)2/2, and is called variance drag. As we move
toward the right on the return-versus risk plot, variance drag increases to the point where

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geometric return begins to fall. Remember, you <eat= geometric annualized return, not
arithmetic return. You are not limited to the corner portfolios, of course. If you decide that
halfway between portfolios 7 and 8 is where you want to be, then you simply average the
compositions of the two portfolios for each asset. Hence, the two fundamental laws of
optimizers:

➢ An optimizer will heavily favour those assets with high historical or assumed returns.

➢ If you can predict the optimizer inputs well enough to come close to the future
efficient frontier, then you don’t need an optimizer in the first place.

The dangers of blindly feeding historical returns, SDs, and correlations into an optimizer
should already be apparent from the above example. Asset returns tend to <mean revert=
over long time periods; an asset with stellar returns over the past 10 years more likely than
not to have below average returns in the subsequent 10 years. Some wags have referred to
optimizers as <error maximiser’s= for just this reason. Some Examples of Portfolio’s are; -

➢ The Madonna Portfolio

Look at a few more examples of how this process works. Assume that you are a bold
investor and have answered the three questions posed earlier in the chapter as follows:

1. Complexity: moderate (level-two palette, plus precious metals)

2. Conventionality: low.

You have determined that you can tolerate a large amount of tracking error and do not mind
at all if your allocation underperforms the S&P 500 for up to a decade, as long as your long-
term returns are reasonable.

3. Risk tolerance: high.

You have shown an ability to withstand large losses in your portfolio without flinching.
Here’s what such a portfolio might look like:

• 10% S&P 500.

• 10% U.S. small stocks.
• 10% REITs.
• 10% international large cap stocks
• 10% international small cap stocks
• 10% emerging markets stocks
• 10% precious metals stocks
• 30% U.S. short-term bonds.

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This portfolio is more or less equally divided between domestic and foreign, and small and
large cap. It is extremely unconventional in this regard, and it will have returns that will be
radically different from the S&P 500 in many years, in either direction. On the other hand, its
long-term returns should be quite high. We hold a fair amount of bonds because the
discounted dividend model tells us that stock returns going forward may not be much greater
than bond returns. This portfolio is not recommended for all but the hardiest of souls and
most independent of thinkers.

➢ The Gap Portfolio

Let’s answer the basic portfolio questions a bit differently:

1. Complexity: high.

We don’t mind holding more than a dozen asset classes.

2. Conventionality: high.

We want adequate diversification and returns, but wish to keep tracking error to a minimum.

3. Risk tolerance: low.

We really don’t want to lose more than about 6% of our net worth in a given year.

The following portfolio is taken from the Dimensional Fund Advisors’ (DFAs) <moderate
balanced= strategy, with low-to-mid risk. This 40/60 stock/bond portfolio is available from
DFA,

• 8% U.S. large-cap growth

• 8% U.S. large-cap value
• 4% U.S. small-cap growth
• 4% U.S. small-cap value
• 4% REIT
• 4% international large-cap value
• 2% international small cap growth
• 2% international small cap value
• 1.2% emerging markets large-cap growth
• 1.2% emerging markets large-cap value
• 1.6% emerging markets small-cap growth.
• 15% one-year corporate bonds
• 15% two-year global bonds
• 15% five-year U.S. government bonds
• 15% five-year global bonds

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First, the complexity of this portfolio should satisfy all but the most exacting portfolio buff,
with no less than 15 asset classes. Secondly, it is quite conventional, with a 28/12
domestic/foreign split,and it is much heavier in large-cap than small-cap stocks. This
portfolio provides adequate safety and diversification, and yet its return only rarely varies
more than a half-dozen percent from a domestic 40/60 S&P 500/T-bill mix.

You now have an idea of how the allocation process works. First, decide how many different
stock and bond asset classes you are willing to own. Increasing the number of assets classes,
you employ will improve diversification but will also increase your work load and tracking
error. The Gap Portfolio gets around this problem with a heavy weighting of large and
domestic stocks in its equity portion. Second, decide just how much tracking error you can
tolerate. If you are unable to tolerate much tracking error, keep your proportion of foreign
and small-cap stocks low. And last, adjust your stock-versus-bond mix according to how
much risk you can tolerate, ranging from a maximum of 75% stock for the most aggressive
investors down to 25% for the least aggressive.

Therefore, it is impossible to forecast future optimal portfolios by any technique. Over the
long term, a widely diversified global portfolio of small-and large-company stocks should
have favourable return-versus risk characteristics. Your precise asset allocation will depend
on three factors: your tolerance to S&P 500 tracking error, the number of assets you wish
to own, and your tolerance to risk.

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4.5 Difference between Ideal Asset Allocation and Present Asset Allocation
When you see your Ideal Asset Allocation, most of you consider the Asset Allocation ONLY
in your present visible investment structure and rarely consider your entire net worth. That is
where the role of a Financial Advisor is very crucial. Ideal Asset Allocation considers your
entire Debt, Equity and alternate investment Portfolio which may include:
Debt:

• Debt Mutual Funds, Liquid funds etc.

• Fixed Deposits, Recurring Deposits, etc.
• Provident Funds and Super-annuation including Employers Provident Fund, Public
Provident Fund, Voluntary Provident Fund, Gratuity, Annuity payable if any.
• Bonds, National Savings Certificates, KVP, etc.
• Current Paid Up Value of Life Insurance Policies

Equity:

• Equities or Equity Oriented Mutual Funds.

• Own Company ESOPs.
• Listed and Unlisted Stocks within India and outside.
• Unit Linked Insurance Plans.

Alternate:

• Property, excluding current residence, within India and outside.

• Gold, Gold coins, Ornaments, etc.
• Watches, Art, other Collectables, etc.
• Cash in Savings/ Current Account or investment in liquid Funds for emergency purposes

When all the above-mentioned aspects are considered and proportionately calculated, the
Present Asset Allocation is determined in terms of total Net worth. The difference between
the two is what needs to be bridged for the long-term healthy maintenance of the portfolio in
order to achieve your financial goals.

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BREAKING DOWN 'Asset Allocation'

There is no simple formula that can find the right asset allocation for every individual.
However, the consensus among most financial professionals is that asset allocation is one of
the most important decisions that investors make. In other words, the selection of individual
securities is secondary to the way that assets are allocated in stocks, bonds, and cash and
equivalents, which will be the principal determinants of your investment results.

Investors may use different asset allocations for different objectives. Someone who is saving
for a new car in the next year, for example, might invest her car savings fund in a very
conservative mix of cash, certificates of deposit (CDs) and short-term bonds. Another
individual saving for retirement that may be decades away typically invests the majority of
his individual retirement account (IRA) in stocks, since he has a lot of time to ride out the
market's short-term fluctuations. Risk tolerance plays a key factor as well. Someone not
comfortable investing in stocks may put her money in a more conservative allocation despite
a long-time horizon.

Age-based Asset Allocation

In general, stocks are recommended for holding periods of five years or longer. Cash
and money market accounts are appropriate for objectives less than a year away. Bonds fall
somewhere in between. In the past, financial advisors have recommended subtracting an
investor's age from 100 to determine how much should be invested in stocks. For example, a
40-year old would be 60% invested in stocks. Variations of the rule recommend subtracting
age from 110 or 120 given that the average life expectancy continues to grow. As individuals
approach retirement age, portfolios should generally move to a more conservative asset
allocation so as to help protect assets that have already been accumulated.

Achieving Asset Allocation Through Life-cycle Funds

Asset-allocation mutual funds, also known as life-cycle, or target-date, funds, are an attempt
to provide investors with portfolio structures that address an investor's age, risk appetite
and investment objectives with an appropriate apportionment of asset classes. However,
critics of this approach point out that arriving at a standardized solution for allocating
portfolio assets is problematic because individual investors require individual solutions.

The Vanguard Target Retirement 2030 Fund would be an example of a target-date fund. As
of 2018, the fund has a 12-year time horizon until the shareholder expects to reach retirement.
As of January 31, 2018, the fund has an allocation of 71% stocks and 29% bonds. Up until
2030, the fund will gradually shift to a more conservative 50/50 mix, reflecting the
individual's need for more capital preservation and less risk. In following years, the fund
moves to 67% bonds and 33% stocks.

The most important determinant of an investor’s long-term investment results is composition

of assets or asset mix in the investor’s portfolio. While factors such as security and manager
selection do matter, statistically speaking, their impact keeps falling as investment horizon
gets longer, leaving asset-allocation as the dominant factor driving investment results.

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Thus, in any financial planning process, arriving at an appropriate asset allocation is the most
important decision variable. In the asset mix, there are likely to be assets which have higher
rewards and higher risk such as equities, and assets which have lower rewards and lower risk
such as government bonds. In other words, over the long term, policy holders cannot expect
equity type of returns by participating in pure debt funds (low risk 3low reward) and vice
versa.
A friend called to celebrate the success of an investment idea. She had purchased shares of a
company a few years ago and it turned out to be a spectacular performer. Her small
investment was now substantial and she felt good about it. Was this going to make a
difference to her wealth.

It is easy to lose track of the big picture that determines how our wealth is growing and how
the different components are feeding it. Mention asset allocation, and most investors think it
is a topic for.
Consider my friend’s wealth after she made the effort to understand what her star stock meant
in macro terms. If her total wealth, including everything of value that she owned, was 100,
she had 40% in the house she lived in, 30% in her provident fund, PPF and post office
accounts, 10% in bank savings account and fixed deposits, 10% in gems and jewellery, 5% in
mutual funds and insurance products and 5% in stocks. This was the asset allocation.

The stock she was exuberant about had grown.

Make asset allocation a strategic decision
How the components will grow will depend on how each one’s value changes.

All figures are assumptions.

This asset allocation provides the much-needed big picture view of wealth. How the
components will grow will depend on how each one’s value changes, and how much our
friend invests on an ongoing basis in them. She has the power to modify the proportions
deliberately, by both moving money around and by making additional contributions from her
savings. The final number of 9% can be modified thus.

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4.6. Determining Asset Allocation by Age: Aligning Financial Goals with

Risk Tolerance Determining

Every year, people set goals such as losing weight, decreasing their spending, increasing their
earnings, or to just be an all-around better person. While over 40% of the population sets
goals for the new year, only 8% of those who set goals actually achieve them. This is a fairly
dismal percentage. Instead of setting lofty goals that are doomed for failure, why not set
smaller goals that could make a real difference on your future investments?

Asset allocation might sound like a complex term, but it’s not. Asset allocation simply
describes what portion of your money is invested in various asset classes. If 70% of the funds
are in stocks and 30% are in bonds, then your asset allocation is 70:30, stocks to bonds.

By owning stock, one actually owns a portion of a company (which is why it is often referred
to as an equity). By owning a bond, an individual is actually a lender to a company and
typically receives interest on the principle. Between these two types of allocations, stocks are
often considered to be higher risk than bonds because of the larger volatility in the market.

Higher risk can lead to greater returns, which is why a common approach investor utilize is to
consider a higher weighting in equities versus bonds early in your career, and increase the
weighting in bonds as you approach retirement, depending on your personal risk tolerance.
Within the past 10 years, growth in the stock market has surpassed the bond market as seen in
the chart below. The bond market as a whole has shown stability during upswings in the
stock market, and has shown relative growth during the down stock markets. In total, the
stock market has certainly been more volatile in the past 10 years, but has also been more
profitable.

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Source: http://static.diffen.com/uploadz/8/8e/Stocks-vs-bonds-growth.png

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RULE OF THUMB

5.1. The Traditional Rule of Thumb

There are many different asset allocation models you can consider seeing which might be
right for you. Once of the simplest is the old rule of thumb, which is calculated with simple
subtraction. Individuals would subtract their age from 100, to quickly discover what percent
of their portfolio should be comprised of stocks. The remaining percent would therefore be
made up on bonds. As an example, a 30-year-old investor could use this guide to invest 70%
of his/her portfolio in stocks and 30% in bonds.

This traditional rule of thumb is just a guide for the average investor that would like to
decrease the risk of their investment portfolio losing value as they grow older. While it does
make sense that one would like to be more protective of their money as they age, is this
traditional rule of thumb still valid today? Some argue that it is outdated because of one
simple factor: people are living longer.

The Updated Rule of Thumb

With an increased average lifespan, many retirees are realizing that their money might not
last. Due to this realization, some have adjusted their rule of thumb model to subtract their
age from 120 instead of 100 to shift their asset allocation from stocks into bonds more
slowly. This adjustment keeps investors more heavily into stocks for 20 years longer than the
traditional rule of thumb. This updated rule of thumb can increase the chance of a larger
retirement fund but it can also increase risk.

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Create Your Own Rule of Thumb

While both the old and new rule of thumb can be helpful in deciding your asset allocation
goals by age, they do not apply to everyone. Some individuals may still be working at age 70
because they have a need to increase their retirement fund. Because of this need, they might
also consider it in their best interest to allocate a greater portion of their investments to the
stock market. Others, however, might have already accumulated a very large nest egg by age
40 and may wish to protect it from the volatility of the stock market. For them, a reduced
allocation in the stock market might be better suited to their desire for lower risk.

There are other factors that could influence asset allocation as well. Besides age and the size
of your retirement portfolio, your ability to withstand risk plays a large role. There are some
that simply can’t sleep at night if their investments are at risk. Due to their discomfort with
market fluctuations, risk averse individuals may choose to invest heavily in bonds and other
more secure investments, and might avoid stocks entirely.

Remember to Maintain Your Allocation

Having a goal to adjust the allocation of your investments as you age is often encouraged,
and is one method that can help reduce surprises to your retirement account and help you
prepare for the future. After deciding what allocation percent is best for you, maintaining that
allocation by rebalancing is incredibly important. With constant market fluctuations, keep in
mind that rebalancing is typically required to maintain your desired allocation ratio.

Some asset allocation products require investors to choose from predefined models that are
unchangeable, which often include overlapped asset classes.

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QUESTIONNAIRE
Before finding out your ideal Asset Allocation, you need to find out your Risk Profile. It is
usually a simple set of questionnaires which determines your risk-taking appetite as far as
your investments are concerned.
The risk profiling is scored and the total of the score is classified into different bands which
determine your intrinsic risk appetite. Each question has a number and the total numbers adds
up to your total score.
Let us take an example of a standard risk profiling questionnaire:
A. Your age:

1. Above 50 years
2. Between 40 to 50 years
3. Between 30 to 40 years
4. Less than 30 years

B. How long will you stay invested, i.e. investment tenure?

1. Between 1-3 years

2. Between 3-5 years
3. Between 5-10 years
4. More than 10 years

C. No of Dependents:

1. More than 3
2. Between 2 to 3
3. Only 1 other than yourself
4. Only Yourself

D. Past Investment Experience

1. No Exposure
2. Little Exposure
3. Moderate Exposure
4. High Exposure

E. What is your primary goal?

1. Preserve the Investment

2. Generate Income
3. Grow the value moderately
4. Grow Money Substantially

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F. Which Portfolio would you prefer?

1. Maximum 5% and Minimum 3% return

2. Maximum 10% and Minimum 0% return
3. Maximum 15% and Minimum -2% return
4. Maximum 20% and Minimum -5% return

And the scoring is like:

• Your score below 14 means you are a Conservative Investor and your Ideal Asset
Allocation should be 50% in Debt Market, 20% in Equity oriented investments and
the remaining 30% in Alternate Investments like Real Estate, Gold, etc.

• Your score between 14 to 18 means you are a Balanced Investor and your Ideal Asset
Allocation should be 35% in Debt Market, 40% in Equity oriented investments and
the remaining 25% in Alternate Investments like Real Estate, Gold, etc.
• And if your score is above 18, it means you are an Aggressive Investor and your Ideal
Asset Allocation should be 20% in Debt Market, 60% in Equity oriented investments
and the remaining 20% in Alternate Investments like Real Estate, Gold, etc.

So, if your answers are:

• You are 35 years old, i.e. 3

• Your investment Horizon is 5-10 years, i.e. 3
• Number of dependents you have are 2, i.e. 2
• Past Investment Experience is Little Exposure, i.e. 2
• Primary Goal of Investment is to Grow the Money Moderately, i.e. 3
• And preferred Portfolio is Maximum 10% and Minimum 0%, i.e. 2

Hence the total score is 3+ 3+ 2+2+3+2= 15. It means you are a Balanced Investor and your
Ideal Asset Allocation should be 35% in Debt Market, 40% in Equity oriented investments
and the remaining 25% in Alternate Investments like Real Estate, Gold, etc.

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CONCLUSION
A lopsided portfolio leaning heavily towards debt-oriented investments stunts the yield
potential while a lean into equity oriented investments result in high volatility. Leaning into
alternate investments of real estate or gold limits liquidity blocks the money for a longer
tenure. Having a balanced portfolio based on your needs is the best course of action as it
would ensure ideal returns and aid in wealth maximization while not being very volatile. As
kids, we heard the saying of not putting all the eggs in one basket and now it is time we
exercise it in our financial planning process. Plan your portfolio through right asset allocation
and enjoy financial success. It is always advisable to avail the services of a financial planner
throughout the journey of your wealth creation.

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BIBLIOGRAPHY

❖ https://www.advisorkhoj.com/iciciprumf/How-to-Achieve-Financial-Goals-through-
Right-Asset-Allocation

❖ https://www.managementstudyguide.com/finance-functions.htm

❖ http://static.diffen.com/uploadz/8/8e/Stocks-vs-bonds-growth.png

❖ The Intelligent Asset Allocator- William. J. Bernstein.

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