Creating An Investment Policy Statement
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In its simplest terms, asset allocation is how an investor divides and allocates his money in his investment portfolio among different investment categories or classes such as stocks, bonds, real estates, mutual funds and cash equivalents. In general, there are 4 main types of asset allocation models for the consideration of different financial objectives and risk tolerance limit: preservation of capital, income, growth and balanced.
Preservation of capital – this is the most conservative asset allocation model. If the investor’s investment horizon is short term, i.e. within the next 12 months, or main consideration is to minimize the risk of losing money, then this is the most suitable asset allocation model to be used. Basically, the asset allocation in this model is heavily weighted on cash or cash equivalent; usually more than 80% to ensure the capital is safe.
Growth – this asset allocation model is designed for those with long time horizon and higher risk tolerance limit. This is most suitable for investors who are relatively young with a higher ability to take risk, such as working professionals who are just starting out in their career and free from short term commitments. They are willing to assume higher risk with the expectation of getting long term capital gain and future wealth generation. This is the most aggressive type of asset allocation model, which is heavily weighted on higher risk investments, such as growth stocks. As risk and return always come hand in hand, portfolio of the growth model tend to shine during the bull market, but it will also be the one that gets hit hardest during the bear market. Therefore, investors who want to use this model must understand the risks involved and ensure that they have a longer time horizon to wait out the volatility in the market until they see returns as based on empirical studies, the growth model has been proven to perform.
Along with personal circumstances and time horizons that change as time passes, the financial objectives of an investor will change accordingly as he moves through different stages of his life. Therefore, after constructing one’s investment portfolio using any one or combination of the above models, the process does not stop there. The investment portfolio will have to be reviewed and certain investment assets in the portfolio may have to be switched to reflect the changing needs and risk tolerance limit of the investor. For example, a middle-aged investor who starts with a balanced portfolio model may want to switch some of his investments from growth stocks to income producing assets, such as fixed income securities or REITs as he approaches retirement.
So far, what we have discussed above is more of a strategic asset allocation, which aims to achieve the investor’s long-term investment objectives based on the longer-term risk and return outlook for the asset classes. However, this does not account for short-term market fluctuation and changing fundamentals of the assets invested. In order to steer the investment portfolio back to its original value weightage or to take advantage of short-term market dynamics, some investors will rebalance their investment portfolio when the opportunities arise.
In summary, the fundamental idea behind asset allocation is to spread money among different asset classes with low correlation with each other in order to reduce the risk of losing our money. This is also known as diversification. By putting together the right combination of asset classes, one may be able to optimize his future wealth generation with limited risk of losing his money.
Ooi Kok Hwa
CFA, CM & AA, MA (Finance), B.Sc (Actuarial Science)
Managing Partner of MRR Consulting