What is Asset Allocation?
Asset Allocation Strategies are the investment strategies that aim to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance, and investment horizon.
Asset Allocation Strategies Simplified
What is Asset Allocation?
- Asset Allocation refers to an investment strategy in which individuals divide their investment portfolios between different diverse assets classes to minimize investment risks.
- The Asset allocation is the balancing of these three components – Return, Liquidity, Risk through investment across different asset classes to achieve a financial goal.
- Thus, the Asset allocation attempts to balance risk versus reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance, and investment horizon.
- The Asset allocation is based on the principle that different assets perform differently in different market and economic conditions. So, It is primarily a hedging exercise that lets you mitigate risks from one asset through investment in other assets.
Factors Affecting Asset Allocation Decision
- When making investment decisions, the investors’ portfolio distribution is influenced by 3 key factors :
- Individual’s Investment Goals :
- 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 invest and risk.
- Level of Risk Tolerance :
- Risk tolerance refers to how much an individual is willing and able to lose a given amount of the 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 other hand, more aggressive investors risk most of their investments in anticipation of higher returns.
- Investment Horizon :
- Time horizon/Investment Horizon factor depends on the duration an investor is going to invest. How long will it be before you need the money?
- 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.
- Individual’s Investment Goals :
Different Asset Allocation Strategies
1. Strategic Asset Allocation
- Strategic Asset Allocation is a passive approach with a more hands-off, long-term decision, typically spanning a decade or more.
- If you have limited investing experience and a long-term horizon, we suggest you sit with your financial advisor and set up these asset allocations.
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2. Tactical Asset Allocation
- The tactical asset allocation strategy addresses the challenges that result from strategic asset allocation relating to the long run investment policies.
- Therefore, tactical asset allocation aims at maximizing short-term investment strategies. As a result, it adds more flexibility in coping with the market dynamics so that the investors invest in higher returning assets.
- In short, Tactical Asset Allocation is a mix of active and passive strategy, if you have medium term horizon, then the investor keeps an eye on short term opportunities.
- Here, you are reallocating money with the same asset classes. For example, if the investor thinks that a recession is looming, he/she may shift more allocation to debt and cash. and when the situation gets better you can go back to the original allocation.
3. Dynamic Asset Allocation
- The dynamic asset allocation is the most popular type of investment strategy among the rest.
- It enables investors to adjust their investment proportion based on the highs and lows of the market and the gains and losses in the economy.
- This is an Active Strategy which is used in many mutual funds, hedge funds. Depending on the market conditions the fund manager decide to change the allocations for tapping market opportunities.
- The main theme is Buy Low Sell High, there is no target allocation as such.
4. Constant Weight Asset Allocation
- The constant-weight asset allocation strategy is a Strategic Asset Allocation strategy with rebalancing at a regular frequency. It is based on the buy-and-hold policy.
- That is, if a stock loses value, investors buy more of it. However, if it increases in price, they sell a bigger proportion. The goal is to ensure the proportions never deviates by more than 5% of the original mix.
- Thus, generally the rule of 5% deviations is followed by the investors. If one asset declines in value, you would purchase more of that asset. And if that asset value increases, you would sell it.
5. Insured Asset Allocation
- For investors prone to risk, the insured asset allocation is the ideal strategy to adopt. It involves setting a base asset value from which the portfolio should not drop from.
- Thus, 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 on analytical research, forecasts, judgment, and experience to decide which securities to buy, hold, and sell with the aim of increasing the portfolio value as much as possible.
- If the portfolio ever drop to the base value, the investor takes the necessary action to avert the risk. In such case, 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 Financial Advisor to reallocate assets, perhaps even changing your investment strategy entirely.
The detailed videos of these allocation strategies are also given below. One should watch these videos for more information about these strategies with examples.