Sam Ghosh

ASSET
ALLOCATION FOR
SMALL INVESTORS
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Table of contents

WHO AND WHY OF THIS

BOOK 1
WHY DO YOU NEED ASSET
ALLOCATION? 3
A PRIMER ON RISK
TOLERANCE 6
DIFFERENT ASSET CLASSES 8
DIFFERENT APPROACHES TO
ASSET ALLOCATION 13
PORTFOLIO REVIEW AND
REBALANCING 15
SOME USEFUL LINKS 19
WHO AND WHY OF THIS BOOK

Au​thor In​for​ma​tion
Sam Ghosh is an Investment Advisor
and Founder of Wisejay Pvt. Limited.
He has an MBA in Fi​nance from Uni​ver​‐
sity of Calgary, Canada, completed all
three levels of the CFA program offered
by the CFA Insititute, USA and holds
var​i​ous NISM cer​tifi​cates.

Why this book?

Investors often end up buying securi‐
ties which are most pro​moted in​stead of
judging the suitability of the asset. This
book is written to introduce asset alloca‐
tion and portfolio creation to the retail
investors. Different asset classes play
different roles in a portfolio. This book
will introduce the investor to the differ‐
ent asset classes and their role in a port‐
folio. This will help the investor under‐
stand suitability of different assets for
them. This book will also introduce dif‐
Asset Allocation for Small Investors 1
fer​ent types of as​set al​lo​ca​tion.

Copy​right
All rights reserved. No part of this
publication may be reproduced, distrib‐
uted, or transmitted in any form or by
any means, including photocopying,
recording, or other electronic or me‐
chanical methods, without the prior
written permission of Wisejay Private
Lim​ited, except in the case of brief quo‐
tations embodied in critical reviews and
certain other noncommercial uses per‐
mit​ted by copy​right law. For per​mis​sion
requests, write to support@wisejay.com,
ad​dressed “At​ten​tion: Per​mis​sions Co​or​‐
di​na​tor,” at the ad​dress be​low.

2 Asset Allocation for Small Investors

WHY DO YOU NEED ASSET
ALLOCATION?

Man​ag​ing un​cer​tainty
One of the issues with the way media
talks about investment performance is
that the returns are given too much im‐
portance and the risks associated with
the returns are often ignored. Gener‐
ally, the higher the return from an in‐
vestment, the higher the uncertainty of
that return. An equity investment which
gave an exceptional return in one year
may not give a positive return next
year. This is the re​al​ity of in​vest​ing.

Professionally trained investors can

bet heavily on very few securityies to
earn alpha (higher return than the mar‐
ket) but most retail investors neither
have the skills nor the risk tolerance to
bet on concentrated assets. This is why,
at least the core long term portfolio of
the investor should have exposure to di‐
verse asset classes and economic sec‐
Asset Allocation for Small Investors 3
tors.

Var​ity of Goals
A retail investor generally has various
financial goals, which she wants to ac‐
complish through a portfolio - growth,
preservation of capital, tax saving, etc.
Only one asset or asset class cannot give
all these benefits. This is why an in‐
vestor must understand the role of dif‐
ferent asset classes and what she can
achieve from them.

Liq​uid​ity Man​age​ment
Institutional investors are well aware
of value of liquidity management. But,
most retail investors are not. Consider
this situation - an investor has high risk
tolerance and based on that he has most
of his portfolio in equity. Now, sud‐
denly something unexpected happened
and he needs cash. Now, nobody can
predict the market conditions exactly at
the time the investor may need money.
The level of uncertainty, associated with
ability to withdraw funds at a favorable

4 Asset Allocation for Small Investors

market condition, increases with the
volatility of the portfolio. That means if
his portfolio has a higher volatility, he
should have a higher liquidity cache to
deal with unforeseen liquidity require‐
ments.

Now, this cannot be achieved without

creating a portfolio mindfully with in‐
tentionally keeping some liquidity in
the portfolio even if that means the
overall return of the portfolio is lower
than the maximum possible. It is an in‐
sur​ance against bad de​ci​sions.

Re​lated Link:
What is Asset Allocation and what you
should know about it?

Asset Allocation for Small Investors 5

A PRIMER ON RISK TOLERANCE

The fundamental principal of invest‐

ing is that the investor must get com‐
pensated for the amount of risk she is
taking. Retail investors need to be clear
about the amount and types of risk ex‐
posure she can take and going to take
through her in​vest​ments.

The amount and type of risk an in‐

vestor take take and want to take is de‐
fined by Risk Tol​er​ance.

What is Risk Tol​er​ance

Risk Tolerance is a measure of how
much risk (investment risk) someone
wants to take and can take. As it appears
there are two classes in Risk Tol​er​ance
a. Risk Attitude: How much risk a per‐
son is will​ing to take?
This is a psychological factor. The in‐
vestors can be classified as ‘Conserva‐
tive Investors’ who prioritise protection
6 Asset Allocation for Small Investors
of principal over higher return or ‘Ag‐
gressive Investors’ who are willing to
risk cap​i​tal for higher re​turn.
b. Risk Capacity: How much risk a per‐
son can actually take based on financial
situation, income sources, age, depen‐
dents in the fam​ily, etc.

Just because someone is willing to

take more risk, does not mean she can.
Investment risk a person can take de‐
pends mainly on Net Worth of the per‐
son compared to amount she needs for
retirement (and other financial goals)
and investment horizon. A young per‐
son can take much more risk than a per‐
son nearing retirement everything else
assumes the same. Source of income
and risk associated with income source
also fac​tors af​fect​ing Risk Ca​pac​ity.

Re​lated Link:
How Much Investment Risk can I
take?

Asset Allocation for Small Investors 7

DIFFERENT ASSET CLASSES

Cash, Debt,
Equity,
Alternative
Assets

Cash
Cash whether it is in your savings ac‐
count or in the form of liquid mutual
funds, represents the lowest risk-return
part of your portfolio. As cash offers
low return, it is a drag on portfolio re‐
turn. People generally park money in
cash either for day to day expenses or
while choosing right investments. A
large amount of cash in the portfolio
may lead to loss of purchasing power as
the return may be lower than the infla‐
tion but useful for liquidity manage‐

8 Asset Allocation for Small Investors

ment.

Bonds
Bonds represent a fixed return part of
your portfolio. Capital appreciation
from bonds is possible when interest
rates fall, but increase in interest rates
introduce interest rate risk. Coupon
bonds also offer periodic cash-flows.
This is especially important for people
who need periodic cash flow for
lifestyle expenses such as retired indi‐
vid​u​als.

Bonds introduce a unique risk to the

portfolio – credit risk. It is the risk that
the bond seller will not be able to make
the interest and principal payments.
The bonds issued by the government
are considered to have no credit risk,
but bonds is​sued by dif​fer​ent cor​po​rates
have credit risk depending on the qual‐
ity of the bal​ance sheet.

Asset Allocation for Small Investors 9

Stocks (Eq​uity)
The role of equity in a portfolio is pri‐
marily capital appreciation in the long
term. Equity prices are volatile and thus
not suitable for short term investment.
There are pri​mar​ily two types of risks in
eq​uity – busi​ness risk, i.e. risk as​so​ci​ated
with the company who issued the stocks
and market risk i.e. risk associated with
the over​all eq​uity mar​ket.

As stocks represent a higher risk-return

characteristic, young investors should
invest a high percentage of their portfo‐
lio in stocks and remain invested for a
long time.

Real Es​tate
Real es​tate in​vest​ment may of​fer pro​tec​‐
tion from inflation and diversification
benefits. Although a prolonged high in‐
flation may force the central bank to in‐
crease interest rates, which negatively
af​fects the de​mand for real es​tate.

10 Asset Allocation for Small Investors

Real estate investments generally offer
higher returns, but adds liquidity issues
to the portfolio. Especially direct real-
estate investments introduces a number
of man​age​ment and liq​uid​ity is​sues.

Pre​cious met​als
Precious metals, such as gold, are used
as a safe haven during market distress.
Precious metals also provide an infla‐
tion hedge. One should keep in mind
that as there is no cash flow before sell‐
ing the metal, the investments can be
highly spec​u​la​tive.

Al​ter​na​tive In​vest​ment
Assets such as art and collectibles are
very less correlated with the other asset
classes and thus offer diversification
benefits. The problem is that assessing
the right value of these assets requires
specialist knowledge and skills. These
as​sets can be purely spec​u​la​tive.

Asset Allocation for Small Investors 11

 Re​lated Link:
What is Asset Allocation and what you
should know about it?

12 Asset Allocation for Small Investors

DIFFERENT APPROACHES TO ASSET
ALLOCATION

Strate​gic As​set Al​lo​ca​tion (SAA)

The discussion above about the risk
tolerance and return objective is com‐
pletely related to Strategic Asset Alloca‐
tion. SAA is about the long term finan‐
cial goals and building a portfolio to
achieve those goals. SAA involves pas‐
sive port​fo​lio man​age​ment and in​volves
less man​age​ment cost.

Tac​ti​cal As​set Al​lo​ca​tion (TAA)

Tactical Asset Allocation is a view based
allocation of assets to take advantage of
market opportunities. The portfolio is
rebalanced based on view on relative
performance of asset classes and in‐
volves active management, making it
ex​pen​sive.

Dy​namic As​set Al​lo​ca​tion (DAA)

Asset Allocation for Small Investors 13
Dynamic Asset Allocation is more of an
automated approach. This operates on a
pre-specified model which does a me‐
chanical rebalancing between asset
classes.

Re​lated Link:
What is Asset Allocation and what you
should know about it?

14 Asset Allocation for Small Investors

PORTFOLIO REVIEW AND
REBALANCING

So, you have done your risk assessment,

decided on the goals, calculated the required
return and decided on your portfolio. Now, you
are done.

Wait, no, not really. Portfolio manage‐

ment is a dynamic process, not a one
time event. You need to review periodi‐
cally whether your portfolio still makes
sense, does it needs any modification.
The process of modifying your portfo‐
lio by selling some assets and buying
some other assets is called Portfolio Re‐
balancing. But Why is a review and re‐
bal​anc​ing re​quired?

WHY REVIEW AND REBALANCING

IS RE​QUIRED?

The reasons can be grouped in three

classes
Asset Allocation for Small Investors 15
1. Economic and Financial Assump‐
tions

The portfolio creation process depends

on var​i​ous as​sump​tions about the fu​ture
economic and market variables – infla‐
tion rate, interest rates, risk free rate,
etc.

With time our economic projections

also change. Your portfolio needs to re‐
flect the changes in the pro​jec​tions.

2. Differences in portfolio perfor‐

mance from ex​pec​ta​tion

It is really difficult (if not impossible) to

predict investment performance. So,
whatever investment performance you
based your portfolio on is expected to
vary from the real performance (better
or worse). That means, you need to pe​ri​‐
odically evaluate the performance of

16 Asset Allocation for Small Investors

the portfolio, benchmark with the ex‐
pected performance, and then rebal‐
ance the portfolio accordingly so that
you can achieve your fi​nan​cial goals.

3. Changes in fi​nan​cial pri​or​i​ties

Our priorities change with time. With

time you may decide to add some new
financial goals and drop some old ones.
It can also happen that the amount you
decided for a financial goal is no longer
valid. Your portfolio needs to be up‐
dated with these changes in pri​or​i​ties.

While portfolio review and rebalanc‐

ing is inevitable, we need to avoid fre‐
quent re​bal​anc​ing. Port​fo​lio re​bal​anc​ing
involves selling some assets (shares,
bonds etc.) and buying new ones. Both
buying and selling involves transaction
costs. Apart from that, there are tax im‐
plications. Frequent rebalancing may
cause you to sell assets too quickly and

Asset Allocation for Small Investors 17

you end up paying short-term capital
gains taxes, which are generally higher
than long term cap​i​tal gains taxes.

The right frequency of rebalancing is

a compromise based on costs and value
cre​ated by re​bal​anc​ing.

Re​lated Link:
Why do we need to Re​view and Re​bal​‐
ance our port​fo​lio?

18 Asset Allocation for Small Investors

SOME USEFUL LINKS

What is Asset Allocation and what you

should know about it?

How Much Investment Risk can I

take?

Why do we need to Re​view and Re​bal​‐

ance our port​fo​lio?

Liquidity Management – Insurance

against bad port​fo​lio de​ci​sions.

Asset Liability Management (ALM)

ap​proach in Per​sonal Fi​nan​cial Plan​ning

Asset Allocation for Small Investors 19