Portfolio Asset Allocation Strategies
Asset allocation refers to the balance between growth- and income-oriented investments in a portfolio. This allows the investor to take advantage of the risk/reward trade off and benefit from both growth and income. Building an appropriate asset mix plays a determinant role in a portfolio's overall risk and return. A portfolio's asset mix should reflect goals at any point in time.
Basic steps to asset allocation consist of:
- Choosing which asset classes to include (stocks, bonds, money market, real estate, precious metals, etc.)
- Selecting the ideal percentage (the target) to allocate to each asset class
- Identifying an acceptable range within that target
- Diversifying within each asset class
Asset allocation can be an active process to varying degrees or passive in nature. Asset allocation strategies outlined in this article should be used only as general guidelines on how investors may use asset allocation as a part of their core strategies.
Constant-Weighting Asset Allocation
Strategic asset allocation generally implies a buy-and-hold strategy, even as the shift in values of assets causes a drift from the initially established policy mix. With this approach, you continually rebalance your portfolio. For example, if one asset is declining in value, you would purchase more of that asset; and if that asset value is increasing, you would sell it.
There are no hard-and-fast rules for timing 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.
Strategic Asset Allocation
This method establishes and adheres to base policy mix, which is a proportional combination of assets (target allocations) based on expected rates of return for each asset class. The portfolio is periodically rebalanced back to those targets as investment returns skew the original asset allocation percentages. For example, if stocks have historically returned 8% per year and bonds have returned 4% per year, a mix of 50% stocks and 50% bonds would be expected to return 6% per year.
The concept is similar to a buy-and-hold strategy, rather than an active trading approach. The strategic asset allocation targets may change over time as the client's goals and needs change and as the time horizon for major events, such as retirement and college funding, grows shorter.
Tactical Asset Allocation
This strategy occasionally engages in short-term, tactical deviations from Strategic Asset Allocation strategy to capitalize on unusual or exceptional investment opportunities. It allows for a range of percentages in each asset class (such as stocks: 40-50%) to take advantage of market conditions. This flexibility adds a market timing component to the portfolio, allowing you to participate in economic conditions 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.
Dynamic Asset Allocation
With active asset allocation strategy you constantly adjust the mix of assets as markets rise and fall, and as the economy strengthens and weakens. With this strategy you sell assets that are declining and purchase assets that are increasing, making dynamic asset allocation the opposite of a constant-weighting strategy. For example, if the stock market is showing weakness, you sell stocks in anticipation of further decreases; and if the market is strong, you purchase stocks in anticipation of continued market gains.
Insured Asset Allocation
When establishing 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.
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.
Integrated Asset Allocation
With integrated asset allocation, you consider both your economic expectations and your risk in establishing an asset mix. While all of the above-mentioned strategies take into account expectations for future market returns, not all of the strategies account for investment risk tolerance. Integrated asset allocation, on the other hand, includes aspects of all strategies, accounting not only for expectations but also actual changes in capital markets and your risk tolerance. Integrated asset allocation is a broader asset allocation strategy, even though allowing only either dynamic or constant-weighting allocation.
