Why is Strategic Asset Allocation an important step in portfolio management? How to combine asset classes: shares, bonds, real estate, private equity, commodities, etc. in the most efficient way?
What is strategic asset allocation?
Strategic asset allocationis definitely the first important step when building your portfolio allocation. In a context of market volatility, it is not sufficient to buy and hold stocks or bonds in an opportunistic manner to weather market shocks. So, first of all, before thinking of investing in single products, investors should step back, think long term (5 to 10 years) and define and build, at the asset class level, the most appropriate portfolio allocation, according to their risk and return profile. This structured approach, based on diversification, that aims to maximize performance at constant risk, is called "strategic asset allocation" and provides an efficient framework to preserve capital over the long term.
What is strategic asset allocation as opposed to tactical asset allocation?
With strategic asset allocation, you aim at building the robust foundations of your portfolio management strategy, with a long-term investment horizon (5 to 10 years), while deciding the right balance between asset classes. On the other hand, with Tactical Asset Allocation (the following step) you aim at taking advantage of short-term market opportunities (market pricing anomalies, strong market sectors, etc.), by selecting the most relevant investment products by asset class and choosing the best market timing. Tactical allocation therefore adjusts the asset allocation in an active and flexible way, unlike strategic allocation, which defines a target allocation over the long term. Both approaches are complementary and will make your portfolio management successful.
What are the benefits of strategic asset allocation?
Efficient strategic asset allocation is an important source of portfolio performance stabilization in the long run: according to a reference research, more than 75% of the variability of a portfolio's returns can be explained by strategic asset allocation. Indeed building the right asset mix from the outset, in line with your personal objectives, is definitely an important step to help you preserve your wealth. If you skip that step, you may end up making the wrong bets on only a few ideas, often based on a risky investment strategy (except if you are the new Warren Buffett, and if so I wish you the very best!) and could be potentially caught in a buy-and-sell spiral. Conversely, strategic asset allocation allows decisions to be made on the basis of clear objectives, without overreacting to market fluctuations.
How to determine a strategic asset allocation?
To perform strategic Asset Allocation, you need to ask yourself right at the beginning several key questions: What is my performance target? What level of loss can I bear? What are my liquidity needs? Do I have a specific timeframe (e.g. retirement) or a project (a property investment, the sale of my private company, etc.)? Then, based on these goals and needs, the next step is to determine the right asset class mix. Strategic asset allocation relies on efficient diversification, leveraging on 3 key parameters about asset classes: their specific risk-return profile, their sensitivity to economic factors (growth and inflation), and the intensity of connections (i.e. correlations) between them to combine them in the most efficient way.
What is a typical strategic asset allocation?
There is no typicalstrategic asset allocation because it depends on the investor's risk-return profile, which can vary substantially from one person to the next! For example, if you are about to retire, and have been investing for 30 years, your main concern may be to clarify and optimize your portfolio allocation to pass it on to your children in a smooth way. Your “ideal” allocation may be completely different from that of a youngentrepreneurwho has just sold his/her company and is planning to set up another business and/or embark on a major real estate project. That said, a typical strategic asset allocation for a rather balanced investor could be: 40% cash & bonds, 30% shares, 15% real estate and 15% alternative investments (private equity, commodities and hedge funds).
FAQs
While asset allocation refers to the percentage of stocks, bonds, and cash in your portfolio, diversification involves spreading your assets across asset classes within those three buckets.
What is the strategic asset allocation? ›
Strategic asset allocation (SAA) is constructed on the basis of long term asset class forecasts with targets to maintain a set combination of asset classes. Dynamic asset allocation (DAA) is an active strategy that adjusts the allocation of assets based on medium term views.
What is strategic asset allocation (CFA)? ›
Strategic asset allocation involves deciding among the various securities within a portfolio and the relative weightings of each. Asset allocation differs from Investor to Investor as the optimal mix depends on the investor's preferences.
What is an example of asset diversification? ›
Real-life examples of assets for portfolio diversification include stocks, bonds, mutual funds, real estate investment trusts (REITs), commodities like gold and oil, and cash equivalents like money market funds or certificates of deposit.
How to create a strategic asset allocation? ›
Strategic asset allocation relies on efficient diversification, leveraging on 3 key parameters about asset classes: their specific risk-return profile, their sensitivity to economic factors (growth and inflation), and the intensity of connections (i.e. correlations) between them to combine them in the most efficient ...
What is an example of a strategic asset? ›
Examples of strategic assets include quality, reputation, managerial skills, brand recognition, patents, culture, technological capability, customer focus, and superior managerial skills (Barney & Zajac, 1994; Castanias & Helfat, 1991; Chakraborty, 1997; Hawawini, Subramanian, & Verdin, 2002; Kogut & Zander, 1993).
What are the issues with strategic asset allocation? ›
The problem lies in the fact that strategic portfolios are not responsive to changes in asset dynamics – changes in expected returns, correlations, and risks. This is why strategic portfolios can get very risky very fast and they reliably result in frequent periods of large loss.
What is the most successful asset allocation? ›
Many financial advisors recommend a 60/40 asset allocation between stocks and fixed income to take advantage of growth while keeping up your defenses.
What is the 4 rule for asset allocation? ›
It's relatively simple: You add up all of your investments, and withdraw 4% of that total during your first year of retirement. In subsequent years, you adjust the dollar amount you withdraw to account for inflation.
How do you diversify your assets? ›
6 diversification strategies to consider
- It's not just stocks vs. bonds. ...
- Use index funds to boost your diversification. ...
- Don't forget about cash. ...
- Target-date funds can make it easier. ...
- Periodic rebalancing helps you stay on track. ...
- Think global with your investments.
Strategic Asset Allocation Example
Suppose 60-year-old Mrs. Smith, who has a conservative approach to investing and is five years away from retirement, has a strategic asset allocation of 40% equities / 40% fixed income / 20% cash. Assume Mrs. Smith has a $500,000 portfolio and rebalances her portfolio annually.
What is the difference between asset allocation and diversification? ›
When it comes to investing, asset allocation is the equivalent of deciding how many of your eggs you're going to put into how many different baskets—or asset classes. Diversification is the spreading of your investments both among and within different asset classes.
What are the benefits of strategic asset allocation? ›
Strategic asset allocation is an investment approach that helps investors to mitigate risk, reduce taxes, and increase returns over a long-term horizon.
What is the purpose of diversification or asset allocation? ›
Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time.
What is asset allocation in simple terms? ›
Asset allocation involves dividing your investments among different assets, such as stocks, bonds, and cash. The asset allocation decision is a personal one. The allocation that works best for you changes at different times in your life, depending on how long you have to invest and your ability to tolerate risk.
What do you mean by diversification? ›
noun. 1. the act or process of diversifying; state of being diversified. 2. the act or practice of manufacturing a variety of products, investing in a variety of securities, selling a variety of merchandise, etc., so that a failure in or an economic slump affecting one of them will not be disastrous.
How do you diversify asset allocation? ›
A diversified portfolio should be diversified at two levels: between asset categories and within asset categories. So in addition to allocating your investments among stocks, bonds, cash equivalents, and possibly other asset categories, you'll also need to spread out your investments within each asset category.
