portfolio selection. Even here separating the process of strategic asset allocation helps in
providing a long-term perspective and an integrated view of the total portfolio.
Portfolio Design: Target Return Approach
In portfolio design, we are essentially concerned with the tradeoff between risk and
return. There are several ways of handling this tradeoff which though apparently
different are ultimately equivalent. We can, as suggested in the previous paragraphs,
decide on the target level of risk that we are willing to take and then try to achieve the
highest level of return that is possible without exceeding this risk level. Alternatively, we
can reverse the logic completely: we can start with a target rate of return and try to keep
the risk as low as possible while still attaining the chosen return objective. A moment’s
reflection will show that these two approaches are only different sides of the same coin.
But there are several situations where an investor may find it easier to specify a target
rate of return than a target risk level. An obvious example is that of a mutual fund which
has promised a certain rate of return to the unit holders. This return plus the management
and operating costs becomes the target rate of return for the fund managers who will then
try to seek the lowest risk route to achieving this target return. Similarly an investor who
is saving for a specific purpose will often have a target amount that he wishes to have at
the end of his holding period. He may, for example, want to have Rs.25 lakhs on his
retirement. From this, he can work out what target return he must achieve to reach this
wealth level given his estimated savings potential.
Asset allocation determines the expected rate of return on the total portfolio to a great
extent because the three asset classes have very different levels of expected return.
Equities are expected to earn more than bonds which in turn probably earn more than
money market instruments. (Of course, the three asset classes rank the same way in terms
of risk also). To achieve a target rate of return, therefore, we have to weight our asset
allocation in favor of higher yielding asset classes (for example, more equities and less
bonds).
Another way to achieve a higher target return is to skew the portfolio within an asset
class in favor of higher return assets. An equity portfolio with a beta of 1.2 would earn
approximately 2% more than the average equity portfolio with a beta of 1.0 (of course at
the cost of higher risk). Similarly, in case of bonds, bonds of long maturity often have
higher yields than short-terms bonds. We may decide to choose these bonds even if it
implies a duration mismatch and higher interest rate risk.
Yet another possibility of earning higher returns arises from superior portfolio selection.
We shall be discussing tactical asset allocation and portfolio selection later in this
chapter. We shall see that investors who have special skills can enhance their return by
performing these tasks better. For instance, investors who are very good at identifying
good scrips which are temporarily undervalued can include such scrips in their equity
portfolio and hope to get returns higher than the average returns of equities as a whole.