Asset Allocation Strategy - Part 2 - Financial consultant Sergey Naumov - information and advice on investment issues

What are current assets

Assets are understood as all own and attracted resources that are used by the enterprise to make a profit.
The classification provides for the grouping of funds according to structural characteristics. The main types of enterprise resources are:

Owned or rented - depending on the type of ownership.
Tangible, intangible, financial - according to forms of functioning.
Current (short-term) and non-current (long-term) - according to the nature of participation in the financial and economic activities of the enterprise.
Liquid and illiquid - according to the degree of liquidity.
Net and total - by sources of formation.

In accordance with the above classification, we will talk about the working resources of the enterprise, the period of use of which does not exceed 12 months from the moment of their acceptance for accounting, commissioning, or no more than one production cycle if its duration is more than 12 months ( clause 19 of PBU 4/99). The remaining groups of funds are classified as non-current (long-term).

Asset Allocation Strategy - Part 2

With a correlation coefficient of -1, a change in the value (yield) of one asset occurs simultaneously with an identical change in the value (yield) of another asset in the opposite direction.

If the correlation coefficient is very close or equal to 0, then the two assets are not related to each other. In other words, a change in the value (yield) of one asset cannot predict a change in the value (yield) of another.

It must be remembered that the correlation coefficient between assets is not a constant value and can change over time.

The investor’s task when compiling a portfolio is to find assets whose changes in value are very weakly related to each other. Unfortunately, in the real world it is virtually impossible to find even two assets that have a strong negative correlation over a long period of time. The best you can find are assets that have a weak negative correlation, no correlation with each other, or a weak positive correlation.

When forming a portfolio, an investor needs to understand how suitable a particular portfolio is for him, made up of different combinations of weakly correlated assets. To assess whether a future portfolio matches the investor's goals and temperament, and what the inclusion of a particular asset in the portfolio will bring, the Asset Allocation strategy uses two main indicators - return and risk.

1.3 Indicators of profitability and risk
Profitability
The profitability of an asset usually means the value of its average annual return.

The average annual return of an asset is calculated as the geometric mean of its annual returns for a certain number of years. Formula for calculating average annual return:

The more years used in calculating the geometric mean, the better. In this case, the average annual return of the asset will take into account as many periods as possible with different economic and financial conditions, to which the value of the asset reacted differently.

The average annual return can also be calculated as follows - the value of the asset at the end of the last year of the period under review is divided by the value of the asset at the beginning of the first year, then the root is taken from the resulting value to a degree equal to the number of years in the period under review:

Risk

In addition to profitability, the risk indicator is equally important when using the Asset Allocation strategy.

In economic theory, there are different definitions of the concept of risk. In the Asset Allocation strategy, the risk of an asset is its market risk, i.e. the risk of a decline in the value of an asset under the influence of various factors.

To assess the level of market risk of an asset, a volatility indicator is used. Volatility measures how volatile the value (return) of an asset is. The wider the range of changes in the value (yield) of an asset, the more risky it is. When investing in assets with high volatility, the risk of losses for the investor will be higher, because... the value of such assets may decline significantly.

Let's look at a simple example. Let’s assume that the value of one asset grew by 1% at the end of the first year, and fell by 2% at the end of the second. The range of changes in value, i.e. The volatility of such an asset is not very high. In turn, the value of another asset grew by 20% at the end of the first year, and fell by 15% at the end of the second year. The range of changes in value, i.e. The volatility of this asset is high. Accordingly, the risk of losing money when investing in the second asset will be higher than when investing in the first.

To compare the risk of different assets and investment instruments, their volatility is calculated mathematically. In the Asset Allocation strategy, volatility is calculated as the mean square or standard deviation. The standard deviation (RMSD) shows how widely the value (return) of an asset is scattered from its arithmetic mean.

The standard deviation of the value or profitability of an asset is calculated as follows - the difference between the value (profitability) of the asset for each individual year and the arithmetic mean for all years is squared, the resulting values are summed up, the sum is divided by the number of years, the square is then extracted from the resulting value root. The formula for calculating standard deviation is given below:

A low MSE value shows that all values of the value (return) of an asset are very close to the average value, and the range of changes in values is small. In turn, a high standard deviation means that the values of the value (return) of the asset vary over a wide range. In other words, the higher the MSE, the higher the risk the asset has.

Standard deviation, of course, is not a completely accurate measure of risk. Some criticize this way of assessing risk. However, it is quite simple to calculate. For an individual investor, the standard deviation is enough to approximately assess the degree of risk when investing in a particular asset, or to determine the degree of risk of the entire portfolio as a whole.

Typically, the higher the risk an asset has, the potentially greater profitability it can bring (although in reality this rule is not always confirmed). But you need to remember that there are no assets with zero risks. Any asset carries the risk for an investor of losing the money invested in it. It’s just that the magnitude of this danger will differ for different assets.

1.4 Selecting asset classes for your portfolio and determining their ratio

In accordance with the Asset Allocation strategy, the investment portfolio does not select individual stocks, bonds, real estate funds, but asset classes that include a large number of stocks, bonds, real estate funds, etc.

Moreover, within each class there can be a division into separate subclasses or groups of assets, which, accordingly, also include a large number of shares, bonds, real estate funds, etc.

Thus, the portfolio is first divided into classes (subclasses, groups) of assets, and then within them is divided into a large number of individual securities and other assets.

Such a portfolio composition allows you to avoid serious losses, for example, in the event of problems of any individual company whose shares are included in the portfolio. If the shares of one company depreciate, this will have little effect on the portfolio as a whole, because it consists of a large number of stocks from different companies, industries and possibly countries.

One of the main goals when investing using the Asset Allocation strategy is to select classes (subclasses, groups) of assets in a portfolio that will have a weak correlation with each other. In other words, which will react differently to the same economic and financial situation.

There is no benefit from including asset groups in a portfolio that have consistently high positive correlations with other asset groups in the portfolio. In turn, the combination of weakly correlated groups of assets will allow obtaining the so-called portfolio effect

– the total risk of the portfolio will be lower than the risk of individual groups of assets included in this portfolio; Plus, the total return of the portfolio in certain cases may be higher than the return of individual groups of assets from the portfolio.

To obtain such an effect, in addition to low correlation between asset groups, it is necessary that each asset group has an expected positive return in the long term. Assets that have low correlation to other assets but negative long-term returns should not be included in your portfolio. At the same time, the expected long-term return of the entire portfolio as a whole should be higher than the inflation rate. In addition, to obtain a portfolio effect, regular portfolio rebalancing is necessary (more on rebalancing below).

Asset allocation reduces, but does not eliminate, risk. There may be periods of time when a diversified investment portfolio will show negative returns. The magnitude of a possible decrease in portfolio profitability depends on the level of risk inherent in it. At the same time, the risk level of the portfolio should be comfortable for the investor. Some people are ready to calmly tolerate a reduction of 5%, but at 10% they will begin to get nervous. Some people don’t panic even with a 20% decline. All people are different. Therefore, there is no universal portfolio. Every investor should have their own unique portfolio. Indeed, in addition to different temperaments and willingness to bear different degrees of risk, each person has his own long-term goals, life situation, level of income and expenses, etc. It is on the basis of these and a number of other parameters that an individual investment portfolio should be compiled.

When compiling a portfolio, the correlation between individual classes (subclasses, groups) of assets is studied, as well as historical risk and return indicators of individual classes (subclasses, groups) of assets and their combinations that form various portfolios. As a basis for calculations, you can use all kinds of stock indices that will reflect the corresponding groups of assets. Based on such calculations, a decision is made on the inclusion of certain groups of assets in the portfolio and on the size of their share in the portfolio.

As a result, the resulting portfolio should reflect a reasonable balance between the level of return that is necessary to achieve the investor's goals and the level of risk that the investor is comfortable with.

Once the composition of the portfolio in terms of classes (subclasses, groups) of assets is determined, you can begin to select specific investment instruments to reflect the selected classes (subclasses, groups) of assets in the portfolio.

2. Selection of investment instruments for the portfolio

As part of the application of the Asset Allocation strategy, the investor needs investment instruments that will sufficiently reflect the required class (subclass, group) of assets.

In addition, you should remember one of the main enemies for investors - the costs of investing. Their value should remain low. Otherwise, the funds that could remain with the investor will go to various financial intermediaries. To do this, you need to select those instruments in your portfolio that invest in which will require minimal costs.

Such inexpensive investment instruments, with the help of which you can create a widely diversified portfolio from various groups of assets from different countries, are, first of all, mutual funds, ETFs and foreign mutual funds.

You must be very careful when selecting investment instruments for your portfolio. Thus, there are differences between ETFs in the level of coverage, the way a particular group of assets is reflected, the amount of management fees, etc. It is important not to get confused in the variety of available instruments. Therefore, you should study in detail, for example, what class (subclass, group) of assets reflects an exchange-traded fund or other exchange-traded product, how accurately the return of the base index is reproduced, what method of index repetition is used, what is the value of the net assets of the fund, how high are the management fees, etc. And only after such a detailed analysis make a decision to include one or another investment instrument in your portfolio.

3. Regular portfolio rebalancing

Another important point in the Asset Allocation strategy is regular portfolio rebalancing.

Rebalancing involves restoring the initially selected ratio of asset classes (subclasses, groups) in the portfolio. This means that after a certain time after the portfolio was formed, it will be necessary to partially sell those groups of assets whose value exceeded the share initially established in the portfolio, and additionally purchase those groups of assets whose value turned out to be lower than the share initially established in the portfolio. As a result of such an operation, the share of each group of assets should again become equal to the original value. However, such rebalancing needs to be done on a regular basis.

Let's look at a simplified example. Let's say a portfolio consists of 50% stocks and 50% bonds. At the end of the year, the share of stocks in the portfolio became 60%, and the share of bonds decreased to 40%. When rebalancing, it is necessary to restore the original ratio of stocks and bonds - 50% to 50%. To do this, you need to sell 10% of the current value of shares and buy an additional 10% of bonds with the proceeds. As a result, the current ratio of stocks and bonds in the portfolio will become equal to the original one.

In addition, similar rebalancing must be carried out within asset classes, if within the portfolio they are divided into smaller subclasses (groups). For example, the bond class (50% of the initial portfolio from the example above) consists of two subclasses - government and corporate bonds. At the same time, government bonds have a share of 30% of the total value of the bond class, and corporate bonds - 70%. If after a year their ratio has changed (for example, the share of government bonds has increased to 40% of the total value of the bond class, and the share of corporate bonds has fallen to 60%), it is also necessary to rebalance within the bond class. Those. sell 10% of government bonds and purchase corporate bonds with this money. And this must be done with each of the asset classes in the portfolio.

It should be taken into account that when rebalancing the investor will incur certain costs. For example, when buying/selling ETF shares that reflect a particular group of assets, in most cases you will have to pay a brokerage commission for the transaction. In addition, when you sell ETF shares that have increased in value, there will be a gain on which you will need to pay taxes.

Therefore, to avoid such expenses, rebalancing can be done when introducing new funds into the portfolio or when withdrawing some funds from the portfolio. When carrying out these operations, you can purchase or sell the corresponding share of assets in order to return to their original ratio.

When depositing new funds or withdrawing part of previously invested funds, expenses for the purchase/sale of ETFs (as well as, possibly, income tax on withdrawal of funds) will be in any case. Rebalancing in such situations will not bring additional costs to the investor.

What does asset rebalancing give? First, potentially higher portfolio returns. Rebalancing is based on a simple logic - sell at a high price and buy at a low price. The investor transfers part of the funds to assets that have fallen in value, counting on their growth and higher profitability in comparison with those assets that have already increased in value. At the same time, assets that have increased in value during such an operation are, accordingly, sold at a higher price than they were initially. Secondly, rebalancing allows you to control the risk of the portfolio, bringing it into line with the originally chosen level. For example, a portfolio of 60% stocks and 40% bonds has one level of risk. When stock prices rise and the ratio of assets in the portfolio changes to 70% stocks and 30% bonds, the risk of the portfolio becomes higher than the initial level. Stocks in this case will play a more prominent role in the portfolio, and a fall in their value will have a stronger effect on it than with a ratio of 60% to 40%. Therefore, in order for the investor not to bear a risk higher than initially expected, it is necessary to rebalance the portfolio.

There are various rebalancing methods. The most popular of them are the calendar and percentage (or dynamic) methods. The first method sets a specific period or date for rebalancing - month, quarter, year. In the second, the percentage value is established, if the share of any asset deviates by which in comparison with its original share, rebalancing occurs. Moreover, it is carried out regardless of how long ago the previous rebalancing took place.

However, the problem with the percentage method is that it is impossible to accurately determine in advance the percentage at which it is most effective to rebalance. This can be well calculated based on the results of past periods, but it is unrealistic to predict it for the future. In addition, the percentage method requires the investor to monitor the market and portfolio more closely.

The easiest to use is the first method – the calendar method. In this case, the standard period for imbalance is 1 year. Annual rebalancing will be quite enough to get the effect of this operation.

To summarize all of the above, it should be noted that the essence of building a portfolio using the Asset Allocation strategy is to select a portfolio of widely diversified asset classes that are weakly correlated with each other and have a projected positive long-term return, combined with regular rebalancing of the ratio of asset classes in the portfolio.

What results the use of such an investment strategy leads to in practice, as well as examples of some portfolios, will be discussed in the next part.

Next part

How is liquidity determined?

Liquidity of current assets is the ability of short-term resources to be converted into cash.

All funds are reflected in the financial statements in increasing order of their liquidity level. Due to the fact that TAs are short-term in terms of circulation speed, they are characterized by the highest degree of conversion into cash.

To calculate the liquid level, the current liquidity ratio is used, showing the institution’s ability to use liquid resources to pay for short-term obligations that have arisen.

The index is defined as the ratio of the TA value to the total indicator of current liabilities, formed from lines 1510, 1520, 1550 of the final financial statements.

Line for reflecting current assets

Based on their maturity, assets are divided into non-current (long-term) and current (short-term). It is current assets that are called current. Current assets are in the balance sheet and there is information on the second section of the balance sheet “current assets”.

This includes the following lines:

1210 – inventories available in the company as of the reporting date;
1220 – the amount of input VAT that was not written off during the reporting period;
1230 – the total amount of debt of debtors, minus long-term debts of counterparties;
1240 – short-term economic investments;
1250 – reserves of money, as well as their equivalents;
1260 – other current assets.

Determination of asset liquidity

Liquidity is the firm's ability to pay its obligations on time. When determining this indicator, much attention is paid to the presence of assets that have the highest rate of conversion into money. It follows that the size of current assets has a direct impact on the solvency of the company and its attractiveness for investment.

The liquidity of current assets is calculated as follows:

KTL = TA / TO.

Where:

KTL – liquidity indicator;
TA – size of current assets;
TO – the amount of current liabilities.

The TO value is determined by adding lines 1510 (borrowed resources), 1520 (accounts payable) and 1550 (other current liabilities). Only short-term debts are used in the calculation.

In order to find out the value of quick liquidity, subtract the size of the MTZ from the size of the TA.

The normal value of KTL should be greater than 1. If a company has this value less than 1, this indicates its low solvency. Too high values of the indicator indicate ineffective use of funds.

Determining the size of current assets

The total of current assets in the balance sheet is line 1200, but provided that their structure does not contain long-term receivables. To calculate such assets, a formula is provided:

At = OA – DZd.