Asset Allocation Strategies

29th June 2021 0 By indiafreenotes

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 mix of stocks, bonds, cash, and real estate in your portfolio is a dynamic process. As such, the asset mix should reflect your goals at any point in time.

Strategic Asset Allocation

This method 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-hold strategy 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.

  1. Age-Based Asset Allocation

Age-based asset allocation is the simpler of the two techniques of strategic allocation.  In the age-based asset allocation technique, the investment decision is based on the age of the investor using the following formula:

Percentage of Equity in Portfolio = (100 – Age of Investor)

For example,  if you are 35 years old, the recommended percentage of equity in your portfolio should be = 100 – 35 = 65%.

While this approach does provide a starting point for asset allocation, it is clearly not sufficient especially as it does not factor in key variables such as your investment objective or your risk tolerance. The second type of strategic allocation technique risk profile-based asset allocation is designed to overcome this limitation.

  1. Risk Profile Based Asset Allocation

This technique of strategic asset allocation is a significant improvement on the age-based method as it uses the investor’s risk tolerance in determining how investments need to be allocated across different types of assets.

This method assigns investors the following 5 labels based on their ability to tolerate risk and volatility in their portfolio:

  • Conservative
  • Income
  • Balanced
  • Growth
  • Aggressive

In this classification system, Aggressive Investors are the most risk-tolerant hence they have the ability to withstand the highest degree of volatility in the portfolio. This is because Aggressive Investors tend to be return-centric and understand the variability of portfolio returns in the short term. On the other hand, Conservative Investors are the least risk-tolerant and prefer to get consistent returns from their investment.

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 course and then rebalance the portfolio to the long-term asset position.

You can avail the benefit of tactical asset allocation by investing in Dynamic Asset Allocation Funds that are also known as Balanced Advantage Funds. These funds use models to change their portfolio exposure to Equity, Debt, and Cash depending on changing market conditions to provide investors an optimal balance between risk and return.

Dynamic Asset Allocation

In this asset allocation strategy, you continuously adjust your asset allocation mix depending on market conditions. The most common dynamic asset allocation strategy used by mutual funds is counter-cyclical strategy. These funds increase their equity allocation (reduce debt allocation) when equity valuations decline (become cheaper) and reduce debt allocations. This is also known as contra strategy. it essentially follows the investment tenet of buying low and selling high. Different fund managers use different valuation metrics for dynamic asset allocation, the most common being P/E and P/B ratios. Some fund managers use multi-factor asset allocation models which combine 2 or more factors e.g. P/E, P/B, Dividend Yield etc. in dynamic asset allocation strategy.

Though dynamic asset allocation based on counter-cyclical or contra strategy is the most common strategy by dynamic asset allocation funds, other asset allocation strategies are also used. A few dynamic asset allocation funds follow a pro-cyclical strategy. The funds increase their equity allocation in rising markets and reduce it in falling markets. Some fund managers believe that following the trend is a good strategy which has worked in the past. Then there are dynamic asset allocation funds, which combine both approaches in what they call, core and tactical approach. The core portfolio (usually 70–80%) follows the typical valuation-based counter-cyclical dynamic asset allocation strategy, while the tactical portion follows a momentum-based approach, which is not dissimilar to the pro-cyclical strategy.

Factors affecting:

  1. Risk tolerance

Risk tolerance refers to how much an individual is willing and able to lose a given amount of their original investment in anticipation of getting a higher return in the future. For example, risk-averse investors withhold their portfolio in favor of more secure assets. In contrast, more aggressive investors risk most of their investments in anticipation of higher returns. Learn more about risk and return.

  1. Goal factors

Goal factors are individual aspirations to achieve a given level of return or saving for a particular reason or desire. Therefore, different goals affect how a person invests and risks.

  1. Time horizon

The time horizon factor depends on the duration an investor is going to invest. Most of the time, it depends on the goal of the investment. Similarly, different time horizons entail different risk tolerance.

For example, a long-term investment strategy may prompt an investor to invest in a more volatile or higher risk portfolio since the dynamics of the economy are uncertain and may change in favor of the investor. However, investors with short-term goals may not invest in riskier portfolios.