The Basics of Investing and Trading

Asset Allocation
Asset Allocation is the process by which the total investble capital is distributed across different asset classes. As discussed in the previous article, asset classes are sets of assets that behave similarly and have similar characteristics, e.g. Stocks, Fixed Income Securities, Commodities and Cash (Cash Equivalents).

Investors typically do not invest all their money in one asset class or one single security. The reasons for this will become obvious as we continue through this article. Asset allocation depends heavily on the individual needs of investors, their risk profiles and unique constraints. Young investors with a high disposable income tend to invest heavily in stocks while middle aged investors tend to invest in balanced portfolios consisting of both stocks and fixed income securities. Retirees tend to invest heavily in high grade debt securities (bonds etc).

As discussed in the previous article, tax structures influence asset allocation. Equities are preferred in countries with high tax rates as taxes typically apply only to dividend income and realized capital gains. The tax drag can be minimized by deferring the realization of capital gains. We will discuss different tax structures and tax drag in a separate article.

A study found that up to 90% of the return of portfolios can be explained simply by asset allocation (as opposed to market timing or other factors). Thus, in my opinion, asset allocation is the single most important part of portfolio management.

Diversification
Diversification is the process of reducing the overall risk of the portfolio by investing in several securities (typically across different asset classes) instead of investing in a single security.

Benefits of diversification
The main benefit over diversification is the reduction of risk (volatility of returns).As we discussed in the previous article; risk is the volatility of returns. Every fund manager would like to have the highest possible return with the lowest possible risk.

Example of the benefits of diversification
Suppose there exist two companies, IcecreamLand and BlanketWorld which manufacture and sell ice-creams and blankets respectively. On hot days, IcecreamLand has high sales and makes a profit of $1 per share while BlanketWorld has low sales and no profits. On cold days, BlanketWorld has high sales and makes a profit of $1 per share while IcecreamLand has very low sales and no profit.

An investor with $2000 to invest could choose to invest in IcecreamLand and/or BlanketWorld. Suppose Mark Alphonso invests $2000 and buys 2 shares of IcecreamLand, George Santino invests $2000 and buys 2 shares of BlanketWorld and Bill Yang too invests $2000 and buys 1 share of IcecreamLand and 1 share of BlanketWorld.

Their returns would be as follows:

Note that all three investors earn the same return i.e. $360 over the entire year, an impressive 18% p.a. However, the important point to note here is that the variance in the total income is different for different investors. Mark Alphonso and George Santino experience huge volatility in their incomes, a semi-annual standard deviation of $255 as opposed to Bill Yang whose semi-annual standard deviation is 0. All three investors got the same return (18%p.a) but Bill Yang’s portfolio was far less volatile and thus far less risky. Thus, Bill’s diversified portfolio outperformed the other two portfolios as it achieved the same return as the other two portfolios despite being much less risky.

The lesson to be taken away from here is that diversification reduces the overall risk of the portfolio. The larger the number of securities, the lower the variance and thus, the lower the risk of the portfolio (assuming a correlation of less than 1 between the stocks).

The importance of correlation
Correlation is a statistical measure that characterizes the linear relationship between two variables. The correlation coefficient measures the strength and nature of that relationship. From a qualitative perspective, the returns of two stocks are positively correlated if the return of one stock increases as the other increases; and are negatively correlated if one increases as the other decreases.

Illustration
Series A: 1, 3, 4,5,6,8

Series B: 3, 4, 6, 8, 6, 9

Series C: -5,-, 3, 1-, 7-, 12,-14

Series A and Series B are highly correlated (correlation coefficient of 0.9) while Series A and Series C are negatively correlated (correlation coefficient of -0.7).

We will cover the quantitative aspects of correlation in a different article. For now it will suffice to understand that the overall volatility (risk) of the portfolio decreases as the correlation between the different in the portfolio decreases.

Monitoring, Rebalancing and Optimization
It is essential for investors to monitor the performance of their portfolios over time and make adjustments as the need arises. Rebalancing is the process of restoring portfolio component weights to their target weights when they change significantly.

Example of rebalancing
Suppose Bob Enslow decides that his portfolio will comprise 60% of equities and 40% of commodities. In August 2008, he invests $6000 in a mutual fund tracking the Dow Jones Industrial Average and $4000 in a commodity mutual fund tracking the Rogers International Commodity Index. Suppose in August 2009, he finds that his equity mutual fund holdings are valued at $10000 and that his commodity mutual fund holdings are valued at $4500. His portfolio now consists of 69% equities and 31% commodities.

In order to restore his portfolio to its original asset weights, he would sell $1300 worth of his equity holdings and invest the returns in a commodity mutual fund. His new portfolio would consist of $8700 worth of equities and $5800 worth of commodities.

Portfolio Management Best Practices

• Come up with a written plan detailing you investment objectives and constraints.
• Diversify across asset classes.
• Diversify your portfolio across different securities within an asset class.
• Don’t trade too often as brokerage and transaction costs may dampen your return.
• Think long term.
• Understand business cycles and their impact on the economy.

Assets and Asset Classes
An asset is anything that is expected to provide positive cashflow in the future. This is a rather broad definition and thus encompasses securities (e.g. stocks, bonds), real estate (e.g. land, houses), intellectual property (e.g. copyrights, patents) etc.

Asset classes are assets that have similar features and behave similarly. The main asset classes are – Equity (stocks), Fixed Income Securities (bonds etc), Commodities (gold, silver, oil, wheat etc), Cash Equivalents (short term deposits, money market instruments) and real estate.

Portfolio
A portfolio is the set of assets held by an individual or an institution. Typically, these assets consist of securities such as stocks, bonds, deposits, bills etc. These individuals/institutions hold these assets, expecting that they will appreciate in value (resulting in a capital gain) and/or provide income throughout their life (e.g. dividends, coupon payments etc).

Portfolio Management
Portfolio Management entails the management of the composition of the portfolio such that it meets the needs of the individual/institution holding it. This typically involves the following steps:
• Assessing the needs of the investor
• Understanding the unique constraints that apply to the investor
• Asset Allocation (deciding how much is invested in each asset class)
• Security Selection (deciding which securities to invest in)
• Portfolio Monitoring
• Adjusting the portfolio to meet changing needs/ market conditions

Understanding investor needs and constraints
Investors have different needs. These needs often stem from the goals of different investors, the unique constraints that they face, their risk profiles, tax environment and their individual natures. For example, a young professional is likely to want to grow his portfolio to meet a specific goal later on, such as an MBA degree, purchase of a home, marriage etc while a wealthy retiree is more likely to be interested in maintaining her standard of living and combating the effects of inflation.

Risk Profiles
Some investors are in a better position to take risks or are more willing to take risks than others. The distinction between the two is important since a willingness to take risk does not necessarily mean an ability to do so. Risk profiles are influenced primarily by age, financial situations and intrinsic natures. For example, young investors with decades of working life left are generally in a better position to make risky investments than older investors who are scheduled to retire in a short while. A young, unmarried IT professional is in a better position to make a risky investment than a single mother who has to provide for her daughter’s education and upkeep.

Thus, understanding your own risk profile before making investments is very important.

Tax Environment
Different countries have different tax structures. Some countries like Singapore have a light tax regime, exempting capital gains from tax, providing generous standard deductions and taxing income at a maximum rate of 15-20%. Countries like Sweden have marginal tax rates as high as 60%. Investors in countries with a high rate of income tax and low capital gains tax would prefer that their investments appreciate in value rather than pay regular dividends while investors in countries with a uniformly light tax structure would be indifferent to the manner in which their investment income presents itself. These are important factors in asset allocation and security selection.

Understanding the tax-liabilities resulting from your investments is critical. Do not ignore it.

We will cover Asset Allocation, Security Selection, Portfolio monitoring and adjustment in the next article.