The ChoosaBroker Trading Academy

4.2. The Importance of Asset Allocation

Nobel Prize winning economist Harry Markowitz once famously described portfolio diversification via asset allocation as “the only free lunch” you will get in the investment game. Numerous academic studies have painstakingly explained the importance of asset allocation in mitigating downside risk. An appropriately allocated portfolio helps smooth out the fluctuations that are intrinsic to financial markets. In this lesson, we will learn about:

What is Asset Allocation?

Asset allocation is the meticulous application of an investment strategy that strives to balance portfolio risk versus reward by regulation the percentage of each asset in the portfolio according to an investor’s expectations, risk appetite and investment time-horizon.

The two primary objectives of asset allocation are to minimize volatility and maximize returns. This is achieved by dividing the investor’s money among diverse asset classes that tend to behave differently over an extended period of time. The Global Financial Crisis and the subsequent recovery provided glaring examples of this disparity in asset performances. U.S. stocks that constituted the SPDR S&P 500 ETF shed almost 37% of their value in 2008. By contrast, fixed income securities tracked by the iShares Core U.S. Aggregate Bond ETF held up nicely during this period, returning close to 8%. However, as the economic outlook brightened in 2009, equities rallied 26% while bonds returned a paltry 3%.

Asset Allocation Strategies

In 1986, the Financial Analysts Journal published a widely-circulated paper titled “Determinants of Portfolio Performance,” which found through empirical evidence that 93.60% of an investor’s return is attributable to asset allocation. The above data suggests that choosing the right allocation strategy could be the biggest determinant of your portfolio’s performance. There are several asset allocation strategies, the most common among which are detailed below:

Strategic Asset Allocation

Strategic asset allocation adheres to the “base policy mix.” It involves fixing target allocations for the different asset classes and rebalancing them periodically so that in case there is significant deviation, the portfolio is returned to the original proportional combination of assets. Suppose that a conservative investor has a strategic asset allocation of 40% stocks, 40% bonds and 20% cash. If the investor allocates $500,000 to his portfolio, the dollar amounts would translate to $200,000 in equities, $200,000 is fixed income $100,000 in cash equivalents. If in one year’s time, the stocks appreciate by 10%, bonds by 5% and cash equivalents by 2%, the portfolio composition would change to $220,000 in equities, $210,000 in fixed income and $102,000 in cash equivalents, with a total portfolio value of $532,000. As a result, stocks now constitute 41.30% of the portfolio, bonds 39.50% and cash 19.20%. To retain his original allocation blend, the investor will have to rebalance the portfolio in such a way that $212,800 is invested in stocks, $212,800 in bonds and the remaining $106,400 in cash equivalents. This is a simplified example of strategic asset allocation.

Tactical Asset Allocation

Over the long run, strategic asset allocation may seem like a rigid strategy. This can result in some proficient investors engaging in occasional tactical deviations from their target allocations to capitalize on short-term investment opportunities like pricing anomalies or strong market trends. Once the short-term opportunities exhaust, the investors revert their portfolios back to the original asset mix. The success of a tactical asset allocation strategy is dependent on a number of factors. An investor needs to have requisite market knowledge and the discipline to construct and execute a tactical strategy. Other factors such as timing, market risk and investment expenses can also impact the performance of a portfolio.

Dynamic Asset Allocation

In dynamic allocation, there is usually no fixed asset mix. The portfolio is frequently adjusted to adapt to changes in the underlying markets. Adjustments generally include lowering exposure to the relatively underperforming asset classes while increasing positions in the outperforming assets. Suppose global stocks have entered a year-long down trend. An investor who uses dynamic asset allocation might reduce her portfolio’s equity exposure and increase the allocation to fixed interest securities in a bid to lower the portfolio’s volatility. If, however, after six months the economy picks-up and equity markets rebound, the investor may decide to increase her stock holdings to benefit from the bullish equity outlook.

Core Satellite Asset Allocation

Core satellite allocation is a fusion of strategic and tactical/dynamic asset allocation strategies. It usually includes a “core” strategic component accounting for the most consequential part of the portfolio, with a tactical or dynamic “satellite” strategy making up the remaining smaller portion. Most core-satellite systems involve gaining exposure to index funds that constitute the stable “core” of the portfolio, while lowly correlated active investments are carefully selected to complete the “satellites” element.

Model Asset Allocation Portfolios

There is no magic formula to find the right asset mix for an individual investor. The composition of each investment portfolio is dictated by the investor’s age, income, investable capital, goals, risk tolerance and time frame. Here are three popular portfolio allocation models that an investor can consider.

Model 1 – The Conservative Portfolio

  • 50% in Medium Term Bonds
  • 20% in Cash Equivalents
  • 20% in Domestic Stocks
  • 10% in Foreign Stocks
  • This is among the more conservative approaches to asset allocation, targeted for investors over 60. It is easy to build and easy to follow. This portfolio is considered conservative because of the large bond ingredient which provides moderate growth, but more importantly, acts as a hedge against equity market downturns. Cash equivalents like money market instruments and commercial papers shield the investor against unexpected expenses.

Model 2 – The Balanced Portfolio

  • 10% in Large Cap Domestic Stocks
  • 10% in Mid Cap Domestic Stocks
  • 10% in Small Cap Domestic Stocks
  • 10% in Foreign Stocks
  • 10% in Commodities
  • 30% in Intermediate Term Bonds
  • 20% in Short Term Bonds
  • This portfolio is tailor-made for any investor over 40, who may seek to strike a balance between growth and safety. Compared to the conservative portfolio, it allocates more to stocks, which have greater return potential. The higher risk is counter-balanced by the 50% bond allotment, with special emphasis on short-term fixed income securities that are likely to fluctuate less in price and result in greater capital preservation.

Model 3 – The Aggresive Portfolio

  • 15% in Large Cap Domestic Stocks
  • 15% in Mid Cap Domestic Stocks
  • 10% in Small Cap Domestic Stocks
  • 20% in Foreign Stocks
  • 20% in Commodities
  • 20% in Medium Term Bonds
  • This portfolio is ideal for investors in the age-group of 18-40, who aspire for greater returns and are willing to expose themselves to correspondingly higher risk. Preservation of principal is not on top of their investment objectives, leading to a modest 20% bond allocation.

Final Few Thoughts

Financial markets are full of surprises and it is virtually impossible for any individual investor to consistently forecast which asset class will go up or go down. Investors as a rule of thumb should review their investment portfolios at least once every quarter. By doing so, the investors can uncover any digressions in their allocations, and take steps to rebalance accordingly.

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