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Friday 15 July 2011

SCDL MBA PROJECT - “Market Risk, How do Mutual Fund Help An Investor to Manage that Risk”



PROJECT REPORT ON
“Market Risk, How do Mutual Fund Help An Investor to Manage that Risk”

INDEX
Sr. No.
Particulars
Pg. No.
1.
Executive Summary.
3
2.
Market Risk.
4
3.
Common Market Risk.
6
4.
How can one Manage Risk.
10
5.
How Does Mutual Fund Help In Managing The Risk.
11
6.
Concept of Mutual Fund.
13
7.
Managing the risk by diversification in terms of Asset Allocation.
14
8.
Asset Allocation Strategies.

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20



29.
Conclusion.
98

Executive Summary


Each and every stock market in the world goes through the risk associated with the investments. This project is about mutual funds, how they are managed,  the risk and returns associated with the portfolio, how the assets are allocated and how an investor should take decision in regards to the assets in his portfolio to minimize risk and increase the returns.

For any portfolio performance, asset allocation is most important factor which is a systematic division and risk management of investment among various asset classes such as fixed income or equities. Asset allocation helps in determining the return on the asset, and of which major part depends on the variation of the securities owned in the portfolio. For maximum return and minimum risk from any portfolio one needs to use a proper asset allocation, and not to rely fully on the financial papers, magazines.

The main purpose for asset allocation is to bring out maximum profit for an investor. An asset allocation is considered through different strategies. For every investor it is very important to understand the market, different stocks in which he is going to invest and the risks and returns associated with these stocks. Each and every investment carries returns and also certain risks. It is on the investor how he uses different strategies of asset allocation in his portfolio. This project is all about how to manage the risk associated with the portfolio with the mutual fund.





Market Risk: What You Don’t Know Can Hurt You

When the Chinese stock market dropped by 9% during a single day in late February 2007, markets around the world quickly felt the impact. In the U.S., the Dow Jones Industrial Average fell by 4.3%, its worst decline since the aftermath of the September 11, 2001 terrorist attacks.

        These events underscore how important it is for investors to understand the concept of market risk, which, like the Chinese stock market example, can result in volatility in one market impacting other markets. Most investors know that investing involves risks as well as rewards and that, generally speaking, the higher the risk, the greater the potential reward. While it is important to consider the risks in the context of a specific investment or asset class, it is equally critical that investors consider market risk.


Difference Between Business Risk and Market Risk

Risks associated with investing in a particular product, company, or industry sector are called business or "non-systematic" risks. Common business risks include:

  • Management Risk
Also called company risk, encompasses a wide array of factors than can impact the value of a specific company. For example, the managers who run the company might make a bad decision or get embroiled in a scandal, causing a drop in the value of the company's stocks or bonds. Alternatively, a key competitor might release a better product or service.


  • Credit Risk
Also called default risk, is the chance that a bond issuer will fail to make interest payments or to pay back your principal when your bond matures.
By contrast, market risk, sometimes referred to as systematic risk, involves factors that affect the overall economy or securities markets. It is the risk that an overall market will decline, bringing down the value of an individual investment in a company regardless of that company's growth, revenues, earnings, management, and capital structure.



Here's an illustration of the concept of market risk: Let's say you decide to buy a car. You can buy a brand-new car under full warranty. Or you can buy a used car with no warranty. Your choice will depend on a variety of factors, like how much money you want to spend, which features you want, how mechanical you are, and, of course, your risk tolerance. As you research different vehicles, you'll find that some makes and models have better performance and repair histories than others.

But whichever car you chose, you will face certain risks on the road which have nothing to do with the car itself, but which can significantly impact your driving experience - including the weather, road conditions, even animals crossing the highway at night. While these factors may be out of your control, being aware of them can help prepare you to navigate them successfully.


Common Market Risks

Depending on the nature of the investment, relevant market risks may involve international as
   well as domestic factors. Key market risks to be aware of include:
  • Interest Rate Risk
     It relates to the risk of reduction in the value of a security due to changes in interest rates. Interest rate changes directly affect bonds - as interest rates rise, the price of a previously issued bond falls; conversely, when interest rates fall, bond prices increase. The rationale is that a bond is a promise of a future stream of payments;
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 an investor will offer less for a bond that pays-out at a rate lower than the rates offered in the current market. The opposite also is true. An investor will pay a premium for a bond that pays interest at a rate higher than those offered in the current market.
For instance, a 10-year, Rs.1, 000 bond issued last year at a 4% interest rate is less valuable today, when the interest rate has gone up to 6%. Conversely, the same bond would be more valuable today if interest rates had gone down to 2%.

  • Inflation Risk
      It is the risk that general increases in prices of goods and services will reduce the value of money, and likely negatively impact the value of investments.
For instance, let's say the price of a loaf of bread increases fromRs.10 to Rs.20. In the past, Rs.20 would buy two loaves, but now Rs.20 can buy only one loaf, resulting in a decline in purchasing power of money.
Inflation reduces the purchasing power of money and therefore has a negative impact on investments by reducing their value. This risk is also referred to as Purchasing Power Risk. Inflation and Interest Rate risks are closely related as interest rates generally go up with inflation. To keep pace with inflation and compensate for loss of purchasing power, lenders will demand increased interest rates.

However, one should note that inflation can be cyclical. During periods of low inflation, new bonds will likely offer lower interest rates. During such times, investors looking only at coupon rates may be attracted to investing in low-grade junk bonds carrying coupon rates similar to the ones that were offered by ordinary bonds during inflation period. Investors should be aware that such low-grade bonds, while they may to a certain extent compensate for the low inflation, bear much higher risks.
  • Currency Risk
It comes into play if money needs to be converted to a different currency to purchase or sell an investment. In such instances, any change in the exchange rate between that currency and Indian Rupee can increase or reduce your investment return. These risk usually only impacts one if one invest in stocks or bonds issued by companies based outside the India or funds that invest in international securities.
For example, assume the current exchange rate of US dollar to British pound is $1=£0.53. Let's say we invest $1,000 in a UK stock. This will be converted to the local currency equal to £530 ($1,000 x £0.53 = £530). Six months later, the dollar strengthens and the exchange rate changes to $1=£0.65. Assuming that the value of the investment does not change, converting the original investment of £530 into dollars will fetch us only $815 (£530/£0.65 = $815). Consequently, while the value of the stock remains unchanged, a change in the exchange rate has devalued the original investment of $1,000 to $815. On the other hand, if the dollar were to weaken, the value of the investment would go up. So if the exchange rate changes to $1 = £0.43, the original investment of $1,000 would increase to $1,233 (£530/£0.43 = $1,233).

  • Liquidity Risk
It relates to the risk of not being able to buy or sell investments quickly for a price that tracks the true underlying value of the asset. Sometimes one may not be able to sell the investment at all - there may be no buyers for it, resulting in the possibility of one’s investment being worth little to nothing until there is a buyer for it in the market. The risk is usually higher in over-the-counter markets and small-capitalization stocks. Foreign investments pose varying liquidity risks as well. The size of foreign markets, the number of companies listed and hours of trading may be much different from those in the India. Additionally, certain countries may have restrictions on investments purchased by foreign nationals or repatriating them. Thus, one may:
(1) have to purchase securities at a premium;
(2) have difficulty selling your securities;
(3) have to sell them at a discount; or
(4) not be able to bring your money back home.
  • Sociopolitical Risk
It  involves the impact on the market in response to political and social events such as a terrorist attack, war, pandemic, or elections. Such events, whether actual or anticipated, affect investor attitudes toward the market in general, resulting in system-wide fluctuations in stock prices. Furthermore, some events can lead to wide-scale disruptions of financial markets, further exposing investments to risks.
  • Country Risk
It is similar to the Sociopolitical Risk described above, but tied to the foreign country in which investment is made. It could involve, for example, an overhaul of the country's government, a change in its policies (e.g., economic, health, retirement), social unrest, or war. Any of these factors can strongly affect investments made in that country. For example, a country may nationalize an industry or a company may find itself in the middle of a nationwide labor strike.
  • Legal Remedies Risk
is the risk that if one has a problem with his investment, he may not have adequate legal means to resolve it. When investing in an international market, one often has to rely on the legal measures available in that country to resolve problems. These measures may be different from the ones you may be used to in the India. Further, seeking redress can prove to be expensive and time-consuming if you are required to hire counsel in another country and travel internationally.

How Can One Manage Risk?

While one cannot completely avoid market risks, one can take a number of steps to manage and minimize them.
  • Diversify:
As in the case of business risks, market risks can be mitigated to a certain extent by diversification - not just at the product or sector level, but also in terms of region (domestic and foreign) and length of holdings (short- and long-term). One can spread his international risk by diversifying his investment over several different countries or regions.
  • Do Homework:
Learn about the forces that can impact your investment. Stay abreast of global economic trends and developments. If you are considering investing in a particular sector, for example, aerospace, read about the future of the aerospace industry. If you are thinking about investing in foreign securities, learn as much as you can about the market history and volatility, socio-political stability, trading practices, market and regulatory structure, arbitration and mediation forums, restrictions on international investing and repatriation of investment.
Learn more about the various types of investments options available to you and their risk levels. Inflation risk can be managed by holding products that provide purchasing power protection, such as inflation-linked bonds.


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 Interest rate risk can be managed by holding the instrument to maturity. Alternatively, holding shorter term bonds and CDs provide the flexibility to take advantage of higher paying instruments if interest rates go up.

Some investments are more volatile and vulnerable to market risks than others. Selecting investments that are less likely to fluctuate with changes in the market can help minimize risks to a certain extent.

HOW DOES MUTUAL FUND HELP IN MANAGING THE RISK
Let us first understand the concept of mutual fund step by step:

History of the Indian Mutual Fund Industry:
The mutual fund industry in India started in 1963 with the formation of Unit Trust of India, at the initiative of the Government of India and Reserve Bank the. The history of mutual funds in India can be broadly divided into four distinct phases

First Phase – 1964-87
Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up by the Reserve Bank of India and functioned under the Regulatory and administrative control of the Reserve Bank of India. In 1978 UTI was de-linked from the RBI and the Industrial Development Bank of India (IDBI) took over the regulatory and administrative control in place of RBI. The first scheme launched by UTI was Unit Scheme 1964. At the end of 1988 UTI had Rs.6, 700 crores of assets under management.

Second Phase – 1987-1993 (Entry of Public Sector Funds)
1987 marked the entry of non- UTI, public sector mutual funds set up by public sector banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC). SBI Mutual Fund was the first non- UTI Mutual Fund established in June 1987 followed by Canbank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92). LIC established its mutual fund in June 1989 while GIC had set up its mutual fund in December 1990.
At the end of 1993, the mutual fund industry had assets under management of Rs.47, 004 crores.

Third Phase – 1993-2003 (Entry of Private Sector Funds)
 With the entry of private sector funds in 1993, a new era started in the Indian mutual fund industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the year in which the first Mutual Fund Regulations came into being, under which all mutual funds, except UTI were to be registered and governed. The erstwhile Kothari Pioneer (now merged with Franklin Templeton) was the first private sector mutual fund registered in July 1993.

The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and revised Mutual Fund Regulations in 1996. The industry now functions under the SEBI (Mutual Fund) Regulations 1996.

The number of mutual fund houses went on increasing, with many foreign mutual funds setting up funds in India and also the industry has witnessed several mergers and acquisitions. As at the end of January 2003, there were 33 mutual funds with total assets of Rs. 1, 21,805 crores. The Unit Trust of India with Rs.44, 541 crores of assets under management was way ahead of other mutual funds.

Fourth Phase – since February 2003
 In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI was bifurcated into two separate entities. One is the Specified Undertaking of the Unit Trust of India with assets under management of Rs.29, 835 crores as at the end of January 2003, representing broadly, the assets of US 64 scheme, assured return and certain other schemes. The Specified Undertaking of Unit Trust of India, functioning under an administrator and under the rules framed by Government of India and does not come under the purview of the Mutual Fund Regulations.

The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and LIC. It is registered with SEBI and functions under the Mutual Fund Regulations. With the bifurcation of the erstwhile UTI which had in March 2000 more than Rs.76, 000 crores of assets under management and with the setting up of a UTI Mutual Fund, conforming to the SEBI Mutual Fund Regulations, and with recent mergers taking place among different private sector funds, the mutual fund industry has entered its current phase of consolidation and growth.

CONCEPT OF MUTUAL FUND

A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is then invested in capital market instruments such as shares, debentures and other securities. The income earned through these investments and the capital appreciation realized are shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost. The flow chart below describes broadly the working of a mutual fund:





The advantages of investing in a Mutual Fund are:

  • Professional Management
  • Diversification
  • Convenient Administration
  • Return Potential
  • Low Costs
  • Liquidity
  • Transparency
  • Flexibility
  • Choice of schemes
  • Tax benefits
  • Well regulated


Managing the risk by diversification in terms of Asset Allocation

Strings, woodwinds and brass. Stocks, bonds and cash. What do these very different things have in common? They are all parts of a whole and when they work together, they perform the way none could alone. An orchestra without violins wouldn't sound as good. And a portfolio without stocks just wouldn't offer peak performance.

Asset allocation is important for portfolio performance. And what exactly is asset allocation? It's a systematic division and risk management of your investment among various asset classes such as fixed income or equities. By having a portfolio that holds different types of investments, you help reduce your risk and portfolio volatility.
Markets and asset classes do not move in tandem: What's hot today may be cold tomorrow. Spreading your investment among different types of asset classes and markets—stocks and bonds, domestic and foreign markets—lets you position yourself to seize opportunities as the performance cycle shifts from one market or asset class to another.

Depending on your investment style and goals, your asset allocation will vary. One should work with his financial advisor to create a personalized asset allocation for his portfolio.
Asset allocation—not stock or mutual fund selection, not market timing—is generally the most important factor in determining the return on your investments. In fact, according to research which earned the Nobel Prize, asset allocation (the types or classes of securities owned) determines approximately 90% of the return. The remaining 10% of the return is determined by which particular investments (stock, bond, mutual fund, etc.) you select and when you decide to buy them.

Consequently, buying a "hot" stock or mutual fund recommended by a financial magazine or newsletter, a brokerage firm or mutual fund family, an advertisement or any other source can be downright dangerous. One should note that recommendations in publications may be out-of-date, having been prepared several months prior to the publication date.

As for market timing—that is, moving in and out of an investment or an investment class in anticipation of a rise or fall in the market—it’s been proven that the modern market cannot be timed. Market timing strategies, such as moving your money into stocks when the market is rising or out of stocks when it’s falling, just do not work.

Asset allocation is the cornerstone of good investing. Each investment must be part of an overall asset allocation plan. And this plan must not be generic (one-size-fits-all), but rather must be tailored to your specific needs.

Sound financial advice from a trusted and competent advisor is very important as the investment world is populated by many "advisors" who either are unqualified or don't have your best interests at heart.

In a nutshell, following are the basic investment guidelines one should live by:
  • Determine your financial profile, based on your time horizon, risk tolerance, goals and financial situation. For more sophisticated investment analysis, this profile should be translated into a graph or curve by a computer program.
  • Find the right mix of "asset classes" for your portfolio. The asset classes should balance each other in a way that will give the best return for the degree of risk you are willing to take. Financial advisors can determine the proper mix of assets for your financial profile. Over time, the ideal allocation for you will not remain the same; it will change as your situation changes or in response to changes in market conditions.
  • Choose investments from each class, based on performance and costs.


WHAT IS ASSET ALLOCATION?


Asset allocation is based on the proven theory that the type or class of security you own is much more important than the particular security itself. Asset allocation is a way to control risk in your portfolio. The risk is controlled because the six or seven asset classes in the well-balanced portfolio will react differently to changes in market conditions such as inflation, rising or falling interest rates, market sectors coming into or falling out of favor, a recession, etc.

Asset allocation should not be confused with simple diversification. Suppose you diversify by owning 100 or even 1,000 different stocks. You really haven’t done anything to control risk in your portfolio if those 1,000 stocks all come from only one or two different asset classes—say, blue chip stocks (which usually fall into the category known as large-capitalization, or large-cap, stocks) and mid-cap stocks. Those classes will often react to market conditions in a similar way—they will generally all either go up or down after a given market event. This is known as "correlation."

Similarly, many investors make the mistake of building a portfolio of various top-performing growth funds, perhaps thinking that even if one goes down, one or two others will continue to perform well. The problem here is that growth funds are highly correlated—they tend to move in the same direction in response to a given market force. Thus, whether you own two or 20 growth funds, they will tend to react in the same way.

Not only does it lower risk, but asset allocation maximizes returns over a period of time. This is because the proper blend of six or seven asset classes will allow you to benefit from the returns in all of those classes.

HOW DOES ASSET ALLOCATION WORK?


Asset allocation planning can range from the relatively simple to the complex. It can range from generic recommendations that have no relevance to your specific needs (dangerous) to recommendations based on sophisticated computer techniques (very reliable although far from perfect). Between these extremes, it can include recommendations based only on your time horizon (still risky) or on your time horizon adjusted for your risk tolerance (less risky) or any combination of factors.

Computerized asset allocations are based on a questionnaire you fill out. Your answers provide the information the computer needs to become familiar with your unique circumstances. From the questionnaire will be determined:
  • Your investment time horizon (mainly, your age and retirement objectives).
  • Your risk threshold (how much of your capital you are willing to lose during a given time frame), and
  • Your financial situation (your wealth, income, expenses, tax bracket, liquidity needs, etc.).
  • Your goals (the financial goals you and your family want to achieve).
The goal of the computer analysis is to determine the best blend of asset classes, in the right percentages, that will match your particular financial profile.

At this point, the "efficient frontier" concept comes into play. It may sound complex, but it is a key to investment success.

WHAT ARE THE ASSET CLASSES?


The securities that exist in today’s financial markets can be divided into four main classes: stocks, bonds, cash, and foreign holdings, with the first two representing the major part of most portfolios. These categories can be further subdivided by "style." Let's take a look at these classes in the context of mutual fund investments:

Equity Funds:    The style of an equity fund is a combination of both (1) the fund's particular investment methodology (growth-oriented, value-oriented or a blend of the two) and (2) the size of the companies in which it invests (large, medium and small). Combining these two variables – investment methodology and company size — offers a broad view of a fund's holdings and risk level. Thus, for equity funds, there are nine possible style combinations, ranging from large capitalization/value for the safest funds to small capitalization/growth for the riskiest.

Fixed Income Funds:   The style of a domestic or international fixed-income fund is to focus on the two pillars of fixed-income performance — interest-rate sensitivity (based on maturity) and credit quality. Thus, fixed-income funds are split into three maturity groups (short-term, intermediate-term, and long-term) and three credit-quality groups (high, medium and low). These groupings display a portfolio's effective maturity and credit quality to provide an overall representation of the fund's risk, given the length and quality of bonds in its portfolio.

HOW ARE ASSET ALLOCATION MODELS BUILT?


Simply stated, financial advisors build asset allocation models by (1) taking historic market data on classes of securities, individual securities, interest rates and various market conditions; (2) applying projections of future economic conditions and other relevant factors; (3) analyzing, comparing and weighting the data with computer programs; and (4) further analyzing the data to create model portfolios.


There are three key areas that determine investment performance for each asset class:
  • Expected return.     This is an estimate of what the asset class will earn in the future—both income and capital gain—based on both historical performance and economic projections.                                                        
  • Risk.        This is measured by looking to the asset class’s past performance.                                                                                                                  If an investment’s returns are volatile (vary widely from year to year), it is considered high-risk.
  • Correlation.   Correlation is determined by viewing the extent it which asset classes tend to rise and fall together. If there is a high correlation, a decision to invest in these asset classes increases risk. The correct asset mix will have a low correlation among asset classes. Correlation coefficients are calculated by looking back over the historical performance of the asset classes being compared. One should note that the ideal asset allocation model for you will change over time, due to changes in your portfolio, market conditions and your individual circumstances. There will probably be shifts in the percentages allocated to asset classes, and possibly some changes in the asset classes themselves.

WHAT IS RIGHT FOR THE INVESTOR?


It’s important to be informed about asset allocation so as to avoid the "cookie cutter" approach that many investors end up accepting. Many of the asset allocations performed today take this "one size fits all" approach.

There are all sorts of investment recommendations continually flowing from the financial press. The key question is: Are they suitable for the investor?

Regardless of the approach one takes, be sure that an asset allocation takes into account his financial profile to the extent feasible.
Asset Allocation Strategies.

Establishing an appropriate asset mix is a dynamic process, and it plays a key role in determining your portfolio's overall risk and return. As such, your portfolio's asset mix should reflect your goals at any point in time. There are a few different strategies of establishing asset allocations, and here we outline some of them and examine their basic management approaches.

The science of asset allocation can be based upon either a fixed approach or it can be dynamic.

Traditional Asset Allocation:

The traditional approach to asset allocation involves setting fixed, or static, allocations of your portfolio between different asset classes or investment types. Traditionally, an investment advisor will consider stocks, bonds, real estate and cash as the primary types of asset classes. Using asset allocation, advisors will recommend how much of your total investment portfolio should be allocated to each asset class or type of investment.

             The fixed asset allocation approach has proven somewhat effective in moderating overall portfolio risk. The strategy works by incorporating a mix of different asset classes with low statistical correlation ... whose price movements tend to be out of synch with each other. The hope is that your various investments won't all be going up or down in value at the same time.  If they do not, then you have reduced the risk of a large loss in your portfolio.

  • Importantly, asset allocation also works by reducing your allocation in historically volatile asset classes such as stocks.

Fixed asset allocation is fundamentally a passive approach. It is based on an academic theory which says that markets are "efficient" and that the price movement of investments cannot be predicted. However, the weakness of the passive asset allocation method is this-
  • At most times over the life of the portfolio, certain assets in the allocation will be seriously underperforming. This simple fact results in a severe inefficiency. The approach doesn’t take the market conditions of any asset class into account.

Traditional asset allocation presents the investor with a difficult tradeoff ... reducing long term returns in order to reduce short-term risk.

 Dynamic and tactical asset allocation.

A "Dynamic" approach to asset allocation can increase returns and also reduce portfolio risk.

The practice of dynamic asset allocation (also called tactical or active asset allocation) has grown in recent years due to the success of various computerized market timing techniques in analyzing market trends. These new technologies typically don’t predict future market movements as much as they identify changes in trend direction and evaluate the risk of changes in a trend. They are good at following the market's trends tightly and reacting quickly to changing condition.

With this advanced technology, the asset allocation practitioner can respond dynamically to the market and significantly increase risk-adjusted return over time by:
  • Avoiding bear markets and periods of under-performance in the various asset classes--either by reducing or eliminating the allocation of the under-performing asset (e.g., getting out of the market).
  • Increasing the allocation of asset classes currently in bull markets that are over-performing.
Therefore, dynamic asset allocation eliminates the key weakness found in the traditional, fixed approach that routinely allows periods of under-performance. The portfolio mix of our generic Model Portfolios will shift dynamically over time to avoid periods of under-performance and move into investment types that are performing well. The net effect is reduced losses, lower volatility, higher average returns and a much stronger risk-adjusted return.

A higher allocation in stocks drives much stronger long-term returns.

The dynamic approach to asset allocation has the inherent ability to tolerate a higher allocation to volatile asset classes such as stocks without increasing the riskiness of your portfolio. This is true when the asset allocation program is driven by advanced market timing technology that can react quickly to changes in market trend.
  • If you can quickly exit the stock market before a bear market can hurt you, why not hold a higher allocation when stocks are performing well and out-performing other asset classes?
The truth is that trends become evident in the markets on a regular basis ... and the trends tend to persist for a period of time. Higher portfolio allocations to the more volatile asset classes can be managed safely in a dynamic approach when a trend can be identified in the asset and a safe exit point can be determined at the time the trend ends.

More efficiently capture changes in sector performance


A passive approach to asset allocation doesn’t allow you to take advantage of periods when Small cap stocks, for example, out-perform large cap stocks or vice-versa. Active asset allocation gives you this ability. You can even use a dynamic approach to capitalize on special asset sectors such as Energy, Precious Metals or International Stocks when they are hot.

Dynamic approaches to asset allocation are inherently more efficient than the traditional, fixed approach. They can significantly boost returns over time by quickly reacting to changing market conditions for various asset classes and sectors, capturing periods of over-performance and avoiding periods of under-performance.



Strategic Asset Allocation

Strategic asset allocation is a method that establishes and adheres to what is a 'base policy mix'. This is a proportional combination of assets based on expected rates of return for each asset class. For example, if stocks have historically returned 10% per year and bonds have returned 5% per year, a mix of 50% stocks and 50% bonds would be expected to return 7.5% per year.

Constant-Weighting Asset Allocation

Strategic asset allocation generally implies a buy-and-hold strategy, even as the shift in the values of assets cause a drift from the initially established policy mix. For this reason, you may choose to adopt a constant-weighting approach to asset allocation. With this approach, you continually rebalance your portfolio. For example, if one asset were declining in value, you would purchase more of that asset, and if that asset value should increase, you would sell it.
There are no hard-and-fast rules for the timing of portfolio rebalancing under strategic or constant-weighting asset allocation. However, a common rule of thumb is that the portfolio should be rebalanced to its original mix when any given asset class moves more than 5% from its original value.

Tactical Asset Allocation

Over the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore, you may find it necessary to occasionally engage in short-term, tactical deviations from the mix in order to capitalize on unusual or exceptional investment opportunities. This flexibility adds a component of market timing to the portfolio, allowing you to participate in economic conditions that are more favorable for one asset class than for others.

Tactical asset allocation can be described as a moderately active strategy, since the overall strategic asset mix is returned to when desired short-term profits are achieved. This strategy demands some discipline, as you must first be able to recognize when short-term opportunities have run their course, and then rebalance the portfolio to the long-term asset position.

Insured Asset Allocation

           With an insured asset allocation strategy, you establish a base portfolio value under which the portfolio should not be allowed to drop. As long as the portfolio achieves a return above its base, you exercise active management to try to increase the portfolio value as much as possible. If, however, the portfolio should ever drop to the base value, you invest in risk-free assets so that the base value becomes fixed. At such time, you would consult with your advisor on re-allocating assets, perhaps even changing your investment strategy entirely.

You can implement an insured asset allocation strategy with a formula approach or a portfolio insurance approach. The formula approach is a graduated strategy: as the portfolio value decreases, you purchase more and more risk-free assets so that when the portfolio reaches its base level, you are entirely invested in risk-free assets. With the portfolio insurance approach you would use put options and/or futures contracts to preserve the base capital. Both approaches are considered active management strategies, but when the base amount is reached, you are adopting a passive approach.

           Insured asset allocation may be suitable for risk-averse investors who desire a certain level of active portfolio management but appreciate the security of establishing a guaranteed floor below which the portfolio is not allowed to decline. For example, an investor who wishes to establish a minimum standard of living during retirement might find an insured asset allocation strategy ideally suited to his or her management goals.

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Conclusion

One should note markets and asset classes do not move in tandem. The investor has to spread his investment among different types of asset classes and markets—stocks and bonds, domestic and foreign markets— so that he can position yourself to seize opportunities as the performance cycle shifts from one market or asset class to another. This spread helps him to get a consistent and better return which will help him to fulfill his financial commitment.

The asset allocation should vary according to the investment style and goals of an investor. For this an investor should take help a Financial Advisor as he has the better knowledge about the various assets which gives better and consistent return, and if the asset is not performing well then he can make the necessary changes in the asset allocation in the portfoilo.

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