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PROJECT REPORT ON “Market Risk, How do Mutual Fund Help An Investor to Manage that Risk”

PROJECT REPORT ON

“Market Risk, How do Mutual Fund Help An Investor to Manage that Risk”

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WHAT IS RIGHT FOR THE INVESTOR?

 

It’s important to be informed about asset allocation so as to avoid the "cookie cutter" approach that many investors end up accepting. Many of the asset allocations performed today take this "one size fits all" approach.

 

There are all sorts of investment recommendations continually flowing from the financial press. The key question is: Are they suitable for the investor?

 

Regardless of the approach one takes, be sure that an asset allocation takes into account his financial profile to the extent feasible.

Asset Allocation Strategies.


Establishing an appropriate asset mix is a dynamic process, and it plays a key role in determining your portfolio's overall risk and return. As such, your portfolio's asset mix should reflect your goals at any point in time. There are a few different strategies of establishing asset allocations, and here we outline some of them and examine their basic management approaches.

The science of asset allocation can be based upon either a fixed approach or it can be dynamic.

Traditional Asset Allocation:

 

The traditional approach to asset allocation involves setting fixed, or static, allocations of your portfolio between different asset classes or investment types. Traditionally, an investment advisor will consider stocks, bonds, real estate and cash as the primary types of asset classes. Using asset allocation, advisors will recommend how much of your total investment portfolio should be allocated to each asset class or type of investment.

             The fixed asset allocation approach has proven somewhat effective in moderating overall portfolio risk. The strategy works by incorporating a mix of different asset classes with low statistical correlation ... whose price movements tend to be out of synch with each other. The hope is that your various investments won't all be going up or down in value at the same time.  If they do not, then you have reduced the risk of a large loss in your portfolio.

 

  • Importantly, asset allocation also works by reducing your allocation in historically volatile asset classes such as stocks.


Fixed asset allocation is fundamentally a passive approach. It is based on an academic theory which says that markets are "efficient" and that the price movement of investments cannot be predicted. However, the weakness of the passive asset allocation method is this-

  • At most times over the life of the portfolio, certain assets in the allocation will be seriously underperforming. This simple fact results in a severe inefficiency. The approach doesn’t take the market conditions of any asset class into account.

 

Traditional asset allocation presents the investor with a difficult tradeoff ... reducing long term returns in order to reduce short-term risk.

 Dynamic and tactical asset allocation.

A "Dynamic" approach to asset allocation can increase returns and also reduce portfolio risk.

The practice of dynamic asset allocation (also called tactical or active asset allocation) has grown in recent years due to the success of various computerized market timing techniques in analyzing market trends. These new technologies typically don’t predict future market movements as much as they identify changes in trend direction and evaluate the risk of changes in a trend. They are good at following the market's trends tightly and reacting quickly to changing condition.

With this advanced technology, the asset allocation practitioner can respond dynamically to the market and significantly increase risk-adjusted return over time by:

  • Avoiding bear markets and periods of under-performance in the various asset classes--either by reducing or eliminating the allocation of the under-performing asset (e.g., getting out of the market).
  • Increasing the allocation of asset classes currently in bull markets that are over-performing.

Therefore, dynamic asset allocation eliminates the key weakness found in the traditional, fixed approach that routinely allows periods of under-performance. The portfolio mix of our generic Model Portfolios will shift dynamically over time to avoid periods of under-performance and move into investment types that are performing well. The net effect is reduced losses, lower volatility, higher average returns and a much stronger risk-adjusted return.

 

A higher allocation in stocks drives much stronger long-term returns.

The dynamic approach to asset allocation has the inherent ability to tolerate a higher allocation to volatile asset classes such as stocks without increasing the riskiness of your portfolio. This is true when the asset allocation program is driven by advanced market timing technology that can react quickly to changes in market trend.

  • If you can quickly exit the stock market before a bear market can hurt you, why not hold a higher allocation when stocks are performing well and out-performing other asset classes?

The truth is that trends become evident in the markets on a regular basis ... and the trends tend to persist for a period of time. Higher portfolio allocations to the more volatile asset classes can be managed safely in a dynamic approach when a trend can be identified in the asset and a safe exit point can be determined at the time the trend ends.

More efficiently capture changes in sector performance

 

A passive approach to asset allocation doesn’t allow you to take advantage of periods when Small cap stocks, for example, out-perform large cap stocks or vice-versa. Active asset allocation gives you this ability. You can even use a dynamic approach to capitalize on special asset sectors such as Energy, Precious Metals or International Stocks when they are hot.

Dynamic approaches to asset allocation are inherently more efficient than the traditional, fixed approach. They can significantly boost returns over time by quickly reacting to changing market conditions for various asset classes and sectors, capturing periods of over-performance and avoiding periods of under-performance. 

Strategic Asset Allocation


Strategic asset allocation is a method that establishes and adheres to what is a 'base policy mix'. This is a proportional combination of assets based on expected rates of return for each asset class. For example, if stocks have historically returned 10% per year and bonds have returned 5% per year, a mix of 50% stocks and 50% bonds would be expected to return 7.5% per year.

Constant-Weighting Asset Allocation


Strategic asset allocation generally implies a buy-and-hold strategy, even as the shift in the values of assets cause a drift from the initially established policy mix. For this reason, you may choose to adopt a constant-weighting approach to asset allocation. With this approach, you continually rebalance your portfolio. For example, if one asset were declining in value, you would purchase more of that asset, and if that asset value should increase, you would sell it.
There are no hard-and-fast rules for the timing of portfolio rebalancing under strategic or constant-weighting asset allocation. However, a common rule of thumb is that the portfolio should be rebalanced to its original mix when any given asset class moves more than 5% from its original value.

 

Tactical Asset Allocation


Over the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore, you may find it necessary to occasionally engage in short-term, tactical deviations from the mix in order to capitalize on unusual or exceptional investment opportunities. This flexibility adds a component of market timing to the portfolio, allowing you to participate in economic conditions that are more favorable for one asset class than for others.

Tactical asset allocation can be described as a moderately active strategy, since the overall strategic asset mix is returned to when desired short-term profits are achieved. This strategy demands some discipline, as you must first be able to recognize when short-term opportunities have run their course, and then rebalance the portfolio to the long-term asset position.

Insured Asset Allocation

 

           With an insured asset allocation strategy, you establish a base portfolio value under which the portfolio should not be allowed to drop. As long as the portfolio achieves a return above its base, you exercise active management to try to increase the portfolio value as much as possible. If, however, the portfolio should ever drop to the base value, you invest in risk-free assets so that the base value becomes fixed. At such time, you would consult with your advisor on re-allocating assets, perhaps even changing your investment strategy entirely.

 

You can implement an insured asset allocation strategy with a formula approach or a portfolio insurance approach. The formula approach is a graduated strategy: as the portfolio value decreases, you purchase more and more risk-free assets so that when the portfolio reaches its base level, you are entirely invested in risk-free assets. With the portfolio insurance approach you would use put options and/or futures contracts to preserve the base capital. Both approaches are considered active management strategies, but when the base amount is reached, you are adopting a passive approach.

           Insured asset allocation may be suitable for risk-averse investors who desire a certain level of active portfolio management but appreciate the security of establishing a guaranteed floor below which the portfolio is not allowed to decline. For example, an investor who wishes to establish a minimum standard of living during retirement might find an insured asset allocation strategy ideally suited to his or her management goals.

Conclusion

 

One should note markets and asset classes do not move in tandem. The investor has to spread his investment among different types of asset classes and markets—stocks and bonds, domestic and foreign markets— so that he can position yourself to seize opportunities as the performance cycle shifts from one market or asset class to another. This spread helps him to get a consistent and better return which will help him to fulfill his financial commitment.

 

The asset allocation should vary according to the investment style and goals of an investor. For this an investor should take help a Financial Advisor as he has the better knowledge about the various assets which gives better and consistent return, and if the asset is not performing well then he can make the necessary changes in the asset allocation in the portfoilo.

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