Asset allocation is a very important part of creating and balancing your investment portfolio. After all, it is one of the main factors that leads to your overall returns—even more than choosing individual stocks. Establishing an appropriate asset mixofstocks, bonds, cash, and real estate in your portfoliois a dynamic process. As such, the asset mix should reflect your goals at any point in time.
Below, we've outlined several different strategies for establishing asset allocations, with a look at theirbasicmanagement approaches.
Key Takeaways
- Asset allocation is very important to create and balance a portfolio.
- All strategies should use an asset mix that reflects your goals and should account for your risk tolerance and length of investment time.
- A strategic asset allocation strategy sets targets and requires some rebalancing every now and then.
- Insured asset allocation may be geared to investors who are risk-averse and who want active portfolio management.
1. Strategic Asset Allocation
Thismethod establishes and adheres to a base policy mix—a proportional combination of assets based on expected rates of return for each asset class. You also need to take your risk tolerance and investment time-frame into account. You can set your targets and then rebalance your portfolio every now and then.
A strategic asset allocation strategy may be akin to a buy-and-holdstrategy and also heavily suggests diversification to cut back on risk and improve returns.
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.
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2. 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. For this reason, you may prefer to adopt a constant-weighting approach to asset allocation. With this approach, you continually rebalance your portfolio. For example, if one asset declines in value, you would purchase more of that asset. And if that asset value increases, you would sell it.
There are no hard-and-fast rules for timing portfolio rebalancing under strategic or constant-weighting asset allocation. But 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.
3. 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 to capitalize on unusual or exceptional investment opportunities. 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 courseand then rebalance the portfolio to the long-term asset position.
The asset mix in your portfolio should reflect your goals at any point in time.
4. Dynamic Asset Allocation
Another active asset allocation strategy is dynamic asset allocation. With this 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 decline and purchase assets that increase.
Dynamic asset allocation relies on a portfolio manager's judgment instead of a target mix of assets.
This makesdynamic asset allocation the polar opposite of a constant-weighting strategy. For example, if the stock market shows weakness, you sell stocks in anticipation of further decreases and if the market is strong, you purchase stocks in anticipation of continued market gains.
5. 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, relying onanalytical research, forecasts, judgment, and experience to decide which securities to buy, hold, and sell with the aim of increasingthe portfolio value as much as possible.
If the portfolio should ever drop to the base value, you invest in risk-free assets, such as Treasuries (especially T-bills) so the base value becomes fixed. At this time, you would consult with your advisor to reallocate assets, perhaps even changing your investment strategy entirely.
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 may find an insured asset allocation strategy ideally suited to his or her management goals.
6. 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 strategies mentioned above account for expectations of future market returns, not all of them account for the investor’s risk tolerance. That's where integrated asset allocation comes into play.
This strategy includes aspects of all the previous ones, 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. But it cannot include bothdynamic and constant-weighting allocation since an investor would not wish to implement two strategies that compete with one another.
The Bottom Line
Asset allocation can be active to varying degrees or strictly passive in nature. Whether an investor chooses a precise asset allocation strategy or a combination of different strategies depends on that investor’s goals, age, market expectations, and risk tolerance.
Keep in mind, however, these are only general guidelines on how investors may use asset allocation as a part of their core strategies. Be aware that allocation approaches that involve reacting to market movements require a great deal of expertise and talent in using particular tools for timing these movements. Perfectly timing the market is next to impossible, so make sure your strategy isn’t too vulnerable to unforeseeable errors.
Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circ*mstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future performance. Investing involves risk, including the possible loss of principal.
