WM3

Understanding Client Situation

&
Asset Allocation

Net Worth
One fundamental relationship that we
need to understand is popularly known as
accounting equation or accounting
equation of the balance sheet. It states:
NET WORTH = ASSETS LIABILITIES

What you own

What you owe

Asset Class Heads

1. Cash and cash equivalents
2. Short-term investments include investment
options bought and held
for sale or till maturity in the near future, i.e., from 3
months to a year.
3. Long-term investments such investments
include investment options horizon, ranging
between 1 3 years and 3 10 years or even beyond.

Asset Classes
Physical
Financial

Types of Liabilities

Home
Auto
Personal
Credit Card
LAS/LAM

Example of a Networth Stmt

Ref Page 23- CPFA

Income and Expenditure Statement

It displays the revenue and the expense

incurred to earn that revenue. Various

Sources of Income
1. Salary income
2. Business/Professional Income
3. Rental Income
4. Investment Income
Types of Expenditures
1. Household expenses
2. Lifestyle expenses
3. Insurance Premiums
4. Loan EMIs & Others

Ratios
Liquidity
Savings
D/E

Client Goals

Major Goals in Life

Childrens Education
Childrens Marriage
Buying a House
Independent Retirement
Minor Goals in Life
Home Renovation
International Vacations
Car Purchase
Holiday Home
Corpus for Start-up
Family Gifting
Other Big Purchases
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Other Financial Goals

Reducing Tax Outgo by Tax Planning
Protection of Assets & Life
Being Debt-free
Charity work

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Life Cycle Model 1 :

A simple approach to optimal consumption can be
created to understand how much a household needs to
save in the early years of higher income, to provide for
retirement.
Income increases steadily in the earning years, and
drops after retirement. Savings and income moves in
tandem.
A rule of thumb is to assume that the average spending
of a household should be not over the average lifetime
income.
If we took the average income upto 100 years, and
equated it to the maximum average consumption during
the life time, we will be able to see how saving and
consumption can be balanced.
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Life Cycle Model -2

Assume that an investors income increases at a steady rate of 6%

p.a from Rs.20,000 a month at age 25 to Rs.150,000 by age 60.
Assume that the pension would be Rs.75,000 after retirement until
age 100.
In the initial years from age 25 to 43, the saving is negative, as
consumption is higher than income. When income exceeds the
average consumption, savings is possible. That period is from 43 to
60 when assets have to be built.
In the post-retirement period income is barely above the
expenditure. Protecting from inflation is the biggest concern in this
period. The life cycle model enables us to understand that the
income, consumption and saving patterns may vary depending on
age of the investors and the life cycle stage they are in.

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Capital Accumulation Model

We assume that income is growing steadily, for simplicity. How the

expense grows over the years, depends on two factors: Inflation and
savings rate. If inflation is lower than rate of increase in income,
notice that higher saving is possible over time (gap between income
and expense).

We deploy the savings into assets which grow over time at a given
rate. We allow them to accumulate in the earning years. At some
point, the assets generate adequate income to cover the expenses
We are ready to retire when income from accumulated assets
exceeds regular income

Depending on how we earn, save and invest, we can decide when

we are ready to retire, using this capital accumulation model.

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Summary

Personal financial management is about managing income, expenses,

assets and liabilities of a household.
The life cycle model provides a basic framework to show how savings in the
early years can fund retirement in later years.
Income of a household may be subject to risks. Planning requires identifying
mandatory expenses and creating assets out of incomes to fund them
Expenses take away a large chunk of income, leaving little to save. Planning
for expenses, funding expenses through a combination of loans and savings
can help balance the finances.
Loans are helpful in managing expenses that shoot above current income
but can be funded with future income.
Household financial statements contain estimates of assets, liabilities and
net worth.
Ratio analysis can be deployed to see how various numbers compare.
Rules of thumb on desirable level for personal finance ratios can be used to
revamp the finances of a household.

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Asset Allocation

Strategic Asset Allocation (SAA)

Strategic asset allocation (SAA) is a long term strategy that uses a
combination of asset classes that suit investor objectives and
constraints, and sticks to that plan for the long run.
There are two aspects to SAA. The first is the determination of
investor objectives and constraints so that the choice of asset
classes is driven by the risk and return preferences of the investor.
The second is portfolio construction that seeks to optimize the
allocation to asset classes given the objectives and constraints.
Every investment advisory organization has its approach to
recording investor objectives and constraints. Usually, an
assessment of the investors situation is made using interviews and
fact finding questionnaires.

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Evaluating SAA

SAA is a long-term strategy that adheres to a chosen allocation

among assets. Rebalancing of the portfolio in SAA would happen
periodically to reset the portfolio to the original asset class weights.

SAA has its advantages. There is no active call on which asset

class is likely to outperform or under perform. A low cost indexation
strategy can be used to implement SAA, eliminating active security
selection as well. The portfolio is always tuned to the objectives as
originally determined.

The disadvantage with SAA is that it may not consider dynamic

changes to asset class performance, or the investors situation from
time to time. Strategic portfolios can thus under perform during bull
runs in assets, when it would systematically take out of a winning
asset class and invest the proceeds into a losing asset class, to
maintain the asset allocation.
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Tactical Asset Allocation (TAA)

We have seen that difference asset classes outperform during different phases of the
economy. TAA is an active asset allcoation strategy that takes a view on asset class
performance and tweaks the allocation on that basis.

The run up in oil prices in 2007, the appreciation in prices of gold in 2006, the upturn
of equity markets in 2003, the easing of interest rates in 2008 are all situations
that are likely to have triggered tactical allocation. Investors would have overweighted or under-weighted these asset calsses to reflect their views. Investors use
TAA when they tilt their portfolios taking a view on asset class performance.
SAA would hold allocations rigidly, while TAA would bring in an element of active
rebalancing, to take advantage of asset prices. Therefore TAA is essentially a market
timing strategy that overweights and underweights asset classes, incorporating a
view about the potential performance of those asset classes.

Investors and managers may deploy TAA in conjunction with SAA, when they revert to
the SAA-driven allocation after a brief period of swerving away.

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Implementing TAA

TAA can be implemented by directly effecting changes to the underlying

portfolio or through derivative positions. A manager can either make a shift
into cash to defend the portfolio from a market correction, or can sell index
futures to implement the same call.

It is important that the investment advisor has the mandate to implement

TAA. TAA is usually implemented within the overall portfolio objectives. Risk
controls are in place to ensure that TAA does not expose the investor
portfolio to undue risks.

Sometimes a small proportion of assets are earmarked to implement TAA,

leaving the rest of the portfolio to be managed strategically. This is called
the core and satellite approach.

TAA also involves rebalancing back to the underlying strategic benchmark.

This is usually done episodically depending on the performance, risks and
market views of the managers.
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Dynamic Asset Allocation (DAA)

DAA as the name suggests is an asset allocation that works on the

basis of a pre-specified model, and is mostly implemented through
structured products, quant models and rebalancing algorithms.

The allocation to each asset class is not a pre-specified percentage,

but varies depending on the performance of several asset class
variables. Several mathematical models have been proposed and
used in DAA, the main objective being creating a mechanical
system that triggers asset allocation and rebalancing.

DAA is used extensively in quant investing, international investing,

structured product portfolios and by hedge funds. It is also an active
management strategy, the tactical shifts triggered by the model,
rather than the manager.

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Summary

There are several motives for which investors save, including retirement, children's
education and the like.
Financial goals are a formal representation of saving motives in terms of amount and
time.
The ability of a household to attain the saving goals depends on demography,
attitudes, income and wealth.
Asset allocation is an investment strategy used to deliver investor saving goals.
Asset allocation is done taking into account the objectives and constraints of
investors.
Model portfolios are assigned to investors after ascertaining their goals and needs
and their risk tolerance.
The objective is to minimise risk given return or maximise return given risk.
There are three approaches to asset allocation - strategic, tactical and dynamic.
Strategic allocation is goal-driven and rebalanced to a fixed ratio; tactical allocation
brings about changes to allocation based on market views; dynamic allocation
involves mechanical rebalancing.
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