The paper analyzes the key principles and the role of asset allocation in the formation of the investment portfolio. It also observes the most common strategies of asset allocation and their advantages. The connection between the asset allocation and the risks and returns of the investment portfolio and their role in the stakeholders’ work will be specified. The investigation on the effect of increasing the investment horizon on the assets management effectiveness will be conducted as well.
The investment portfolio, including asset allocation, diversification, and rebalancing, follows basic principles. These principles are not someone’s particular point of view, but a certain standard, which has to be followed by a contemporary investor. Asset allocation is a kind of breakdown of the investment portfolio into the individual asset classes including stocks, bonds, money, etc. In addition, everyone who has the portfolio decides how and which combinations of assets to include in his/her portfolio. The asset allocation, which appears to be the most acceptable and most appropriate for the investor at a given time, depends mainly on his/her choice of the time horizon and his/her risk tolerance.
The investor protects him/herself from the significant losses if the portfolio includes various categories of the assets, the returns of which may rise and fall in various market situations. It is well known that the main categories of the assets do not fall and rise simultaneously. The market conditions allow one of these categories of the assets to stay on top, while the other categories show the inferior results. Investing in several asset classes reduces the risk of losing money, and the asset allocation strategies allow getting the total profit of the portfolio smoother. Thus, the asset allocation is a key element of a successful investment strategy. Therefore, it is noteworthy to analyze the basic features of the asset allocation and investigate the effect of increasing the investment horizon on the effectiveness of the asset management to figure out its importance for the investment portfolio.
The Importance of the Asset Allocation
The formation of the investment portfolio includes not only the selection of the assets and specific investment instruments, but their proper allocation in the portfolio as well. The investment portfolio may include a variety of assets: stocks, bonds, real estate, money, precious metals, etc. The asset allocation is a strategy, according to which one allocates the investments to different asset classes in accordance with their age, risk tolerance and financial goals. The asset allocation is highly individual, depending on many factors, and reflecting the circumstances and needs of each particular investor (Vanguard Asset Management, 2015). It is challenging for the investor to choose wisely the structure of his/her assets for his/her purposes and needs.
There are two major strategies of the asset allocation. The first one is the strategic asset allocation (passive), which assumes the selection of the optimal portfolio structure for the risk and return ratio of the long-term investment (Eychenne, Martinetti, & Roncalli, 2011). According to this strategy, the investor does not predict the behavior of the assets and profitability. The portfolio does not change depending on the current economic and market situation. The assets ratio may be revised or adjusted, if some changes occur in the investor’s life or when his/her financial goals vary.
The tactical asset allocation is the strategy, which assumes the recurrent changes of the assets structure in the portfolio activated by the investor, depending on the current situation in the economy and the market as well as the expected return of the assets (Eychenne, 2011). The tactical asset allocation helps the investor to significantly reduce the risk of his/her investment as its foremost objective (as in the case of diversification) is to minimize the risk in an attempt to preserve the profits.
Each asset has certain unique features, so asset allocation influences whether the investor’s portfolio satisfies his/her purposes and objectives or not (Vanguard Asset Management, 2015). On the other hand, every investor has his/her own degree of risk tolerance. Someone is psychologically prepared for the possibility of sustaining a loss, and for someone, the losses may simply be unacceptable. Not everyone is able to cope with emotions and fear, while witnessing the fall of their investments value, and without selling the portfolio with the losses. The portfolios may fall by about 20%, 30%, 40% or even more. Typically, the stocks, the commodity assets (gold or silver) and the real estate may fall heavily during the crisis. Thus, one may consider them as the risky assets. The bonds fall less during the crisis, and money (cash and deposits) usually do not fall at all (Vanguard Asset Management, 2015). Therefore, one may consider them as the low risk assets. If the investor fears even a temporary dropping of these investments not being resistant to the risk, the larger part of the portfolio should be occupied with the deposits and bonds as the least risky assets. However, one should note that in this case, the potential return on the portfolio reduces, and therefore, one has to invest more money to achieve his/her goals.
Invite your friends and get bonus from each order they
The start-up capital, returns of the investment and the amount of the additional investment influences whether the investor reaches his/her financial goals by the deadline or not (Vanguard Asset Management, 2015). Regarding the future returns on one’s investments, it may not be accurately known beforehand. The profitability of all assets including bonds, deposits, and real estate is not stable. Therefore, one can only talk about the anticipated future profitability. As for the estimated future returns of the asset, the investors often take its long-term historical average yield. Thus, according to the varying proportion of the assets, one can apply the theoretically expected return of the portfolio.
Even in case the company’s bankruptcy is anticipated, asset allocation allows the stakeholders not to lose the money invested during the purchase of this company’s shares, and to sell their shares to the investors to gain a certain amount of them with the timely assessment of the market situation. The investors’ expectations regarding the company’s profits affect the price of its shares and bonds. The stakeholders, who expect the reduction of the company’s profits, will sell the shares, which may lead to the decrease of their market value. Similarly, if the investors expect the increase of the company’s profits, they will pay the higher price for its shares. Undoubtedly, the stakeholders holding the shares only are at a great risk, as they fall into one of the most risky asset classes because they can collapse at any moment. However, precisely because of the difference in the prices of sold and purchased shares the stakeholders can increase their profits. Thus, the distribution of assets is a key factor in the work of stakeholders as well.
While approaching the financial targets, the investors gradually reduce the share of the risky assets towards the safe ones – deposits and bonds. If at the moment of the financial goal the financial crisis occurs, a large proportion of the stocks and other risky assets in the portfolio will drastically fall, and the money will not be enough at the given moment. Based on this fact, one can formulate the basic rules of the asset allocation concerning the time of the financial goals achievement. The longer the investment and the risk tolerance are, the greater the share of the risky assets (stocks, real estate, and commodity assets) in the portfolio is. Similarly, the smaller the period of the investment and the risk tolerance are, the greater the proportion of the stable assets (deposits and bonds) in the portfolio is. However, it is noteworthy that people, who prefer the portfolio with the higher proportion of the bonds, will be forced to invest more in order to catch up with those ones, who invest in the stocks. On the other hand, the investors, who invest in the stocks, should be ready for a strong subsidence of the portfolio. However, allocating the assets, one can find the golden mean in this case.
Another foremost concept in the investment theory is the rebalancing of the portfolio (Vanguard Asset Management, 2015). As the assets go up and down at different speed, one asset can increase while the other one may fall. As a result, their ratio would deviate from the initial portfolio composition. Therefore, it is necessary to conduct the periodical rebalancing of the portfolio, bringing the deviated ratio of the assets in the portfolio to the original one.
There are two ways of conducting the portfolio rebalancing. The first one involves the sale of the asset, which has exceeded its allotted share, and the purchase of a cheapened one, using these funds. The second way of conducting the portfolio rebalancing includes the introduction of the additional finances and buying cheapened assets with the help of these finances. In the markets with the trend (up or down) the absence of rebalancing increases the return of the portfolio. In its turn, rebalancing the portfolio increases the returns in the side (not trending) markets and decreases them in the trend ones, since during the uptrend the investors sell the most growing assets, while during the downtrend they buy the most falling ones. Generally, rebalancing of the portfolio reduces its volatility. However, in some cases, it may increase due to the purchase of the assets, which keep falling. The optimal frequency for the rebalancing of the investment portfolio is once a year. Too frequent rebalancing reduces the effect of the volatility and too rare causes its eventual missing (Vanguard Asset Management, 2015).
The Investigation of the Influence of Increasing of the Investment Horizon on the Effectiveness of the Asset Management
To investigate the effect of the increasing of the investment horizon on the asset management effectiveness, one can select the risks of the possible strategies of the long-term unchanged asset allocation as the main target of the analysis. Classical theory suggests that the risk decreases with the increase of the investment period (Siegel, 2008). However, eventually, in case of the same portfolio the uncertainty concerning the future and, thus, the final yield increases. The greater the investment period, the higher the probability of various extreme and rare events is, including the global crisis and downturn in the single financial market. The similar events can cause, for instance, the short-term negative returns of the assets in the portfolio and lead to the loss of funds. This, in turn, may increase the volatility of the returns and decrease the final yield. Thus, in this case the assumption suggests that the risk and return are behaving differently, rather than converging, as was shown in Siegel work (Siegel, 2008).
The empirical analysis was carried out on the example of the most comprehensive global portfolio diversification. To achieve this, the stocks of the Exchange Traded Funds with the various investment strategies, as well as the stock market indexes all over the world were selected (Bloomberg, 2016). This allowed obtaining meaningful and sustainable results based on the data from the most diverse samples of the assets and taking into account the possibility of different investment strategies of the ETF and the financial markets of the developed countries.
The following set of tools, which contains the historical series of the daily returns for the period of10 years, according to Bloomberg Agency statistics (2005-2015), was selected, and includes: CAC Index – French stock index; FTSE100 Index – British stock index; NKY Index – Japanese stock index; DAX Index – the German stock index; RTSI Index – Russian stock index (Bloomberg, 2016). The analysis was carried out for three different investment periods: one year, 5 and 10 years. This allowed considering the change of the intertemporal characteristics of the possible portfolios during the short, medium and long-term periods.
In Table 1, one can observe the values of the sample mean values of annual returns for all of the selected assets and every time interval (Bloomberg, 2016). It is noteworthy that the average yield of the individual instruments shows the projected decline in accordance with the Siegel’s theory only for a few tools: SHY US Equity – the US bond fund with the investment grade; LQD US Equity and IEF US Equity – the funds of the medium and long-term US government bonds; IVW US Equity and IWN US Equity — the equity funds; IYT US Equity and IBB US Equity – the funds of the transport and biotechnology companies (Bloomberg, 2016). A notable trend of decreasing the profitability with the increasing of the investment period is revealed only in about a half of the selected tools. The other indexes and funds can be characterized by the absence of such a trend, or in some cases by increasing the mean.
The Returns of the Instruments during the Various Time Horizons (% per Annum)
ILF US Equity
SPY US Equity
SHY US Equity
VB US Equity
IGE US Equity
SLYV US Equity
LQD US Equity
IEF US Equity
IWN US Equity
IVW US Equity
EFA US Equity
GLD US Equity
IYT US Equity
IBB US Equity
For example, the Russian and French indexes (RTSI and SAS, respectively) showed a distinctly negative profitability in 2014-2015, which is the annual gap in the present analysis. However, with the increase of the period to 2005-2015 years they showed highly positive returns. Thus, one cannot talk about reducing the profitability for them. Such an outcome can be caused by the market fluctuations during the selected period (for instance, the crisis of 2008-2009).
Table 2 shows the results of the calculations of the standard deviation in the average annual return for the mentioned periods for all tools based on the daily timeframe. One can observe the growth of the standard deviation with the lengthening of the time horizon. This can be explained by the fact that during the period extension the sample size of the daytime observations greatly increases (252, 1258, 2497 observations respectively, for 1 year, 5 and 10 years). In some cases, this results in the range expansion, and in others, this causes a more frequent occurrence of its extreme values. As a result, both the variance and standard deviation increase as well.
Sample Standard Deviation of the Instruments during Various Time Horizons (% per Annum)
SPY US Equity
ILF US Equity
SHY US Equity
VB US Equity
IGE US Equity
SLYV US Equity
LQD US Equity
IEF US Equity
IWN US Equity
IVW US Equity
EFA US Equity
GLD US Equity
IYT US Equity
IBB US Equity
Analyzing the data on the individual indexes one can observe that the extension of the time horizon of the investment involves increasing of the potential profitability rate fluctuations and the probability of increasing the average risk. During the longer period, the tools profitability can take the extreme values in the current historical range or even go beyond the historical limits. As a result, for several days the portfolio can show abnormally low returns with the immutability of its composition throughout the investment period.
To explore more deeply the hypothesis that the increase of the investment horizon causes the growth of the differences in the risk value of different asset allocation strategies, one should analyze the change of the possibility of the global diversification with the increasing of the investment horizon. It may allow refining the understanding of the comparative advantages of various combinations of the long-term asset classes traded in various financial markets.
The empirical analysis of the global diversification between different investment strategies (based on the ETF data) and the markets was executed on the basis of 19 tools listed in Table 1. Based on the daily data, the yield and risk measures for the investment horizons of 1 year, 5 and 10 years were simulated. The average annual return on the portfolio with the asset allocation was defined as the average daily yield of the portfolio for the whole investment period, multiplied by the standard number of the trading days per year (252). The average annual measure of the risk portfolio with the asset allocation was calculated as the product of the standard deviation of the daily return on the portfolio over the period of the investment T on √252 (standard conversion to a constant value as a part of the standard deviation). This definition of the portfolio characteristics allowed taking into account the fluctuations in the entire investment horizon and reflecting the volatility as the standard deviation in the analysis. It is especially important for the comparison of different strategies of the long-term investment and research of the opportunities to diversify and improve the effectiveness of the long-term investment funds.
Based on 19 index portfolios mentioned earlier, the plurality of the portfolios was obtained by simulating more than 14 thousand possible combinations. This set of different asset allocations includes the average-weighted portfolios with the equal weight for each asset and portfolio, consisting of 100% of each asset separately. The rest of the combinations characterize the different strategies of the long-term asset allocations more fully. At the same time, in each of the data sets, the benchmarks were allocated, namely the portfolios that consist of the shares of only one of the index portfolios. They included: SHY US Equity as an indicator of the risk-free rate of return, which is characteristic of the short-term government securities; SPY US Equity as an indicator of the profitability of the 500 largest US issuers included in the S & P 500 Index; LQD US Equity as a benchmark yield of the US issuers, who have the investment grade; the portfolio with the provisional name “Full diversification”, which consists of the shares of all 19 index portfolios with the equal weight; and the portfolio of the RTS index.
Figure 1 shows the boundary of the set of portfolios with the investment horizon of 1 year, 5, and 10 years. Among the annual portfolios, one can observe the substantial variation of minimum and maximum values of the yield and risk. Many portfolios provide the set of efficient portfolios with a yield of about 0 to 34.3% per annum. The portfolios that play the role of benchmarks are located approximately in a single line.
In the case of the set of portfolios with the investment period of 5 years, the significant dispersion of the minimum and maximum values of the yield and risk indicators remains, however, in case of the yield, it occurs noticeably less frequently than in case of the annual portfolios. The majority of the efficient portfolios provide a set of combinations of the funds with a yield of about 0.2 to 27.8% per annum. The portfolios, which play the role of benchmarks, are located approximately in a single line.
The spread of the minimum and maximum values of the risk indicators rises with the increase of the investment horizon up to 10 years while the difference between the maximum and minimum average annual yield of the set of portfolios is decreasing. The majority of the efficient portfolios provide a set of the combinations of funds with the yield of about 0.4 to 15.9% per annum. None of the possible portfolios with the investment horizon of 10 years has a negative average annual yield that would show the benefit of the portfolio diversification over time. The portfolios, which play the role of benchmarks, are located approximately in a single line as well.
While the horizon of investment is increasing, the diversification impact on the relationship between the profitability and risk of the portfolios significantly weakens. Thus, for the ratio of the yield and the risk of the portfolio, the allocation of different classes of the investment assets becomes more important than the diversification strategy of their representatives, which essentially defines mainly the portfolio risk and to a lesser degree, its profitability.
Top Writer Your order will be assigned to the most experienced writer in the relevant discipline. The highly demanded expert, one of our top 10 writers with the highest rate among the customers.Hire a top writer for $10.95
While setting the boundaries of the portfolios with the investment horizon of 1 year, 5, and 10 years, it becomes clear that with the extension of the time horizon the spread of the portfolios profitability reduces with the increase of the range of changes of the standard deviation value. Table 3 summarizes the resulting empirical research of the portfolios, aggregated data about the maximum and minimum values of the yield and risk for portfolios with the investment horizons of 1 year, 5, and 10 years.
Summary of the Returns and Risk of the Portfolios with Various Investment Time Horizon
The annual portfolios yield parameters vary in the range from -31.6% to + 34.3%, while standard deviation (risk) varies from 0.5% to 26.9%. In 5-years portfolios with the narrowing of the spread, the average annual yield ranges vary from -2.5% to + 27.8%; the difference in the portfolios of the standard deviation values remained virtually unchanged, ranging from 0.9 to 26.9% per year. With the rising of the investment horizon up to 10 years, there is a tendency for the increase of the risk dispersion indicators (from 1.6 to 35.5%), and the decrease of the difference between the highest and lowest average yields of the portfolios (from 0.4 to 15.9%) per annum.
The conducted researches on the basis of the sufficiently large and representative sample of the different investment strategies with the investment period of up to 10 years showed that the plurality of the portfolios compresses along the yield measures axis, and consequently, expand along the risk measures axis. Therefore, during the long-term investment, the most important aspect is to determine the target ratio of the returns and the risk of the portfolio as well as the allocation of the various classes of the investment assets. Thus, the asset allocation plays one of the foremost roles during the long-term investment.
The asset allocation is a strategy, according to which one allocates the investments among the different assets’ classes in accordance with their age, risk tolerance and financial goals. It is highly individual, as it depends on many factors, and reflects the circumstances and needs of each particular investor.
The asset allocation is extremely important for the success of the investment portfolio. Thus, the tactical asset allocation helps the investor significantly reduce the risk of his/her investment, as its foremost objective is to minimize the risk in an attempt to preserve the profits. The asset allocation allows the investor to choose the suitable asset classes concerning the particular risk perception level. By varying the proportion of the assets, one can apply the theoretically expected return of the portfolio.
Concerning the portfolio’s profitability, the situation is the following. It is noteworthy that people, who prefer the portfolio with the higher proportion of the bonds, will be forced to invest more in order to catch up with those ones, who invest in the stocks. On the other hand, the investors, who invest in the stocks, should be ready for a strong subsidence of the portfolio. However, allocating the assets, one can find the golden mean in each case.
There is another foremost concept in the investment theory– rebalancing of the portfolio, which is extremely important for the investment portfolio. It is necessary to conduct the periodical rebalancing of the portfolio, bringing the deviated ratio of the assets in the portfolio to the original one. In the markets with the trend (up or down) the absence of rebalancing increases the return of the portfolio. In its turn, rebalancing the portfolio increases the returns in the side (not trending) markets and decreases them in the trending ones. Generally, rebalancing of the portfolio reduces its volatility. However, in some cases, it may increase due to the purchase of the assets, which keep falling.
Struggling with your essay?
Ask professionals to help you!
The main results of the investigation on the effect of the increasing of the investment horizon on the assets management effectiveness are the following. The increase of the investment horizon causes the growth of the differences in the risk values of the different asset allocation strategies. The extension of the time horizon of the investment involves increasing of the potential profitability rate fluctuations and increasing the average risk. During the longer period, the tools profitability can reach the extreme values in the current historical range or even go beyond the historical limits. As a result, during the period of several days the portfolio can show abnormally low returns with the immutability of its composition throughout the investment period.
The conducted researches on the basis of the sufficiently large and representative sample of the different investment strategies with the investment period of up to 10 years showed that the plurality of the portfolios compresses along the yield measures axis, and on the contrary, expands along the risk measures axis. Therefore, during the long-term investment, the most important issue is to determine the target ratio of the returns and the risk of the portfolio as well as the allocation of various classes of the investment assets. Thus, the asset allocation plays one of the foremost roles during the long-term investment.