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Asset allocation, simply put, is the answer to, “how much of my investable surplus do I put in different asset classes, so that I meet my goals without taking undue risks?”
Assets classes typically include equity, debt, gold/commodities and real estate. Portfolio skewed towards Equity delivers higher returns but exposes you to a higher risk. Portfolio skewed towards Bonds or debt funds is secure (low risk) but delivers lower returns. Allocation to equity-debt is done based on your risk profile which is a combination of your willingness and ability to handle risk. It classifies you as conservative, moderate or aggressive. When your allocation to equity is higher than what your risk profile recommends you are carrying an asset allocation risk. However, when it is lower you are carrying the risk of earning lower returns. The answer lies in rebalancing the equity-debt mix back to what is recommended by your risk profile.
Yes. When the equity-debt allocation depends on your risk profile and the market levels it is called Smart or Dynamic Asset allocation. At a fair market level, the mix reflects what the risk profile recommends. If the market is at higher than fair value levels, Smart/Dynamic Asset Allocation reduces the exposure to equity and vice-versa. This method of allocation works very well in bear and volatile markets. In bull markets, its performance depends on the assessment of what is the fair value of the market.
When you invest a significant portion of your portfolio, typically more than 25%, in a single sector, or in multiple sectors that are highly correlated, your portfolio is subject to sector exposure risk.
Companies in the same sector are likely to be impacted by the same economic factors. Or sometimes the same economic factor adversely impacts multiple sectors. For example a sharp increase in interest rates is likely to have a negative effect on both banking and infrastructure sectors. The market reacts and prices fall, sometimes sharply. Therefore a large exposure to a single sector, or correlated sectors, could result in a drastic fall in your portfolio market value.
Sector exposure may not always be a bad thing. Taking this risk is justified only when compensated with good returns. For this you must be sure that the sector/companies will bounce back in the time frame you are willing to remain invested and that the current prices are very attractive.
It is best to consult a fiduciary investment advisor before chasing higher returns at the cost of sector exposure risk.
Investing a significant portion, typically more than 10% of your portfolio in a single stock, is exposing your portfolio to stock exposure risk.
A stock is exposed to several company specific risks, namely business, balance sheet, valuation or people risk. Therefore a higher investment in one stock, has a disproportionately large impact on portfolio performance. A 20% drop in a stock that comprises 20% of your portfolio reduces your absolute returns by 4%.
Stock exposure can also occur unintentionally. As a value investor you may have made a sizeable investment in a stock when it was attractively priced. Over time, as a result of both the company performance and the market prices, it can become concentrated in your portfolio. Your dilemma then is should you retain or reduce your holding.
It is not possible to resolve this with a simple yes/no answer and you need to consult your fiduciary investment advisor. However, caution requires you to be aware of this risk, and sooner rather than later, reduce your exposure.
An often overlooked source of risk in a stock is the size of its market capitalization; a measure of what the market thinks the company is worth.
The performance of small companies, some with weak business models, can deteriorate quite easily. Their performance could be affected by economic downturn, spurt in commodity prices, business problems faced by their large customers, lack of resources, etc. There is the additional risk of not knowing enough about the company, since small caps are not studied as closely as large caps. This exposes you to the risk of poor governance and fraud.
However, the potential of high returns from small caps should not be ignored. Small cap companies with a good business model grow faster, which leads to a large rise in their stock prices and results in very good returns.
If you have a moderate risk profile, you should invest not more than 20% in small caps. This will enable you to participate in the potential for growth from small caps, while limiting the market capitalization risk to your overall portfolio. Simultaneously, invest 60% in large caps with low volatility and steady returns.
Companies with poor fundamentals and weak business models are unable to deliver consistent and sustainable profitable growth. Investing in such stocks exposes your portfolio to business risk. The company's poor performance could be the result of low or no sales growth, poor margins, inefficient management, inefficient capital allocation, etc.In the short term, it is possible that even substandard business gives temporary returns. But in the long term, a company's performance is reflected in its stock returns. As rightly said by Benjamin Graham, the father of Value Investing, “In the short term the market behaves like a voting machine, but in the long term it acts like a weighing machine.“
Invest in a business that behaves like a compounding machine; companies that perform consistently and have sustainable earning power. Such performance will translate into higher market values and earn you compounded returns.
Even large or prominent companies are not immune to business risk. Investing in companies with business risk means you run the risk of loss of value from falling prices. The returns generated by buying healthy companies can be wiped out because of such bad investments.
When an asset is overpriced as compared to its fair value, your portfolio is exposed to valuation risk. Valuation risk impacts return on investment, as the more overvalued the asset is, the lower the probability of return for the investor.
Over valuation is usually a temporary phenomenon. Sooner or later, due to self correcting mechanism, the price of such stocks will fall, either gradually or often with a dramatic crash. If you have overpriced stocks forming a large portion of your portfolio, as the price reduces your portfolio value will decrease, even if the correction is only to its fair value.
Don't believe the myth that you can time the market, sell at the highest price or get out at the peak. If you have access to fair value of the company, compare the CMP. This will help you gauge where the stock stands from a valuation perspective. It is safer to sell overvalued stock and book profits, at least partially. And invest in fundamentally strong companies at attractive prices to continue to earn good returns and avoid valuation risk.
When an asset has low trading volumes and cannot be traded quickly without a significant impact on market price, it exposes you to liquidity risk. This is evident for small companies that have a small free float, or any company in which a significant portion of issued shares are held by promoters, government, strategic partners, etc. and not traded regularly.
Since there are not many buyers in the market you cannot sell stock quickly. You will only be able to sell large quantities at rapidly decreasing prices.
If an asset is carrying liquidity risk without other risks, you should start selling gradually. However, if the asset is exposed to liquidity risk accompanied by other risks too, your risk is compounded. It is better to exit such assets immediately.