Portfolio Strategy Mix

Asset allocation refers to an investment strategy in which individuals divide their investment portfolios between different diverse asset classes to minimize investment risks. The asset classes fall into three broad categories: equities, fixed-income, and cash and equivalents. Anything outside these three categories (e.g., real estate, commodities, and art) is often referred to as alternative assets.

Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals and investment time frame. The focus is on the characteristics of the overall portfolio. Such a strategy contrasts with an approach that focuses on individual assets.

Factors Affecting Asset Allocation Decision

An investors’ portfolio distribution is influenced by factors such as personal goals, level of risk tolerance, and investment horizon.

1. Goals factors

Goals 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.

2. 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. On the contrary, more aggressive investors risk most of their investments in anticipation of higher returns. Learn more about risk and return.

3. 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-time 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.

Allocation strategy

There are several types of asset allocation strategies based on investment goals, risk tolerance, time frames and diversification. The most common forms of asset allocation are: strategic, dynamic, tactical, and core-satellite.

Strategic asset allocation

The primary goal of strategic asset allocation is to create an asset mix that seeks to provide the optimal balance between expected risk and return for a long-term investment horizon. Generally speaking, strategic asset allocation strategies are agnostic to economic environments, i.e., they do not change their allocation postures relative to changing market or economic conditions.

Dynamic asset allocation

Dynamic asset allocation is similar to strategic asset allocation in that portfolios are built by allocating to an asset mix that seeks to provide the optimal balance between expected risk and return for a long-term investment horizon. Like strategic allocation strategies, dynamic strategies largely retain exposure to their original asset classes; however, unlike strategic strategies, dynamic asset allocation portfolios will adjust their postures over time relative to changes in the economic environment.

Tactical asset allocation

Tactical asset allocation is a strategy in which an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for perceived gains. While an original asset mix is formulated much like strategic and dynamic portfolio, tactical strategies are often traded more actively and are free to move entirely in and out of their core asset classes.

Core-satellite asset allocation

Core-satellite allocation strategies generally contain a ‘core’ strategic element making up the most significant portion of the portfolio, while applying a dynamic or tactical ‘satellite’ strategy that makes up a smaller part of the portfolio. In this way, core-satellite allocation strategies are a hybrid of the strategic and dynamic/tactical allocation strategies mentioned above.

Problems with asset allocation

There are various reasons why asset allocation fails to work.

• Investor behavior is inherently biased. Even though investor chooses an asset allocation, implementation is a challenge.
• Investors agree to asset allocation, but after some good returns, they decide that they really wanted more risk.
• Investors agree to asset allocation, but after some bad returns, they decide that they really wanted less risk.
• Investors’ risk tolerance is not knowable ahead of time.
• Security selection within asset classes will not necessarily produce a risk profile equal to the asset class.
• The long-run behavior of asset classes does not guarantee their shorter-term behavior.