Establishing an appropriate asset mix is a dynamic process, and it plays a key role in determining your portfolio's overall risk and return. As such, your portfolio's asset mix should reflect your goals at any point in time. Here we outline some different strategies of establishing asset allocations and examine their basic management approaches.
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. 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.
Constant-Weighting Asset Allocation
Strategic asset allocation generally implies a buy-and-hold strategy, even as the shift in values of assets causes a drift from the initially established policy mix. For this reason, you may choose to adopt a constant-weighting approach to asset allocation. With this approach, you continually rebalance your portfolio. For example, if one asset is declining in value, you would purchase more of that asset; and if that asset value is increasing, you would sell it.
There are no hard-and-fast rules for timing portfolio rebalancing under strategic or constant-weighting asset allocation. However, a common rule of thumb is that the portfolio should be rebalanced to its original mix when any given asset class moves more than 5% from its original value.
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.
Dynamic Asset Allocation
Another active asset allocation strategy is dynamic asset allocation, with which you constantly adjust the mix of assets as markets rise and fall, and as the economy strengthens and weakens. With this strategy you sell assets that are declining and purchase assets that are increasing, making dynamic asset allocation the polar opposite of a constant-weighting strategy. For example, if the stock market is showing weakness, you sell stocks in anticipation of further decreases; and if the market is strong, you purchase stocks in anticipation of continued market gains.
Insured Asset Allocation
With an insured asset allocation strategy, 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 to try to increase the portfolio value as much as possible. If, however, the portfolio should ever drop to the base value, you invest in risk-free assets so that the base value becomes fixed. At such time, you would consult with your advisor on re-allocating assets, perhaps even changing your investment strategy entirely.
Insured asset allocation may be suitable for risk-averse investors who desire a certain level of active portfolio management but appreciate the security of establishing a guaranteed floor below which the portfolio is not allowed to decline. For example, an investor who wishes to establish a minimum standard of living during retirement might find an insured asset allocation strategy ideally suited to his or her management goals.
Integrated Asset Allocation
With integrated asset allocation, you consider both your economic expectations and your risk in establishing an asset mix. While all of the above-mentioned strategies take into account expectations for future market returns, not all of the strategies account for investment risk tolerance. Integrated asset allocation, on the other hand, includes aspects of all strategies, accounting not only for expectations but also actual changes in capital markets and your risk tolerance. Integrated asset allocation is a broader asset allocation strategy, albeit allowing only either dynamic or constant-weighting allocation. Obviously, an investor would not wish to implement two strategies that compete with one another.
Asset allocation can be an active process to varying degrees or strictly passive in nature. Whether an investor chooses a precise asset allocation strategy or a combination of different strategies depends on that investor's goals, age, market expectations and risk tolerance.
Keep in mind, however, that this article gives only general guidelines on how investors may use asset allocation as a part of their core strategies. Be aware that allocation approaches that involve anticipating and reacting to market movements require a great deal of expertise and talent in using particular tools for timing these movements. Some would say that accurately timing the market is next to impossible, so make sure your strategy isn't too vulnerable to unforeseeable errors.
Investing BasicsThere are many strategies to help balance your portfolio. Here are a few to get you started.
Investing BasicsUnderstanding the different asset classes is an essential part of portfolio diversification.
Investing BasicsMinimizing risk while maximizing return is any investor's prime goal. The right mix of securities is the key to achieving your optimal asset allocation.
Options & FuturesNot all investors are incredibly brave with their money. Thankfully, there are ways to measure your risk level.
Options & FuturesCollars are extremely flexible, and can be much more beneficial to your portfolio than asset allocation.
Investing BasicsSo if you want to go double, consider these five classic strategies to help turn your vision into a reality.
InvestingThe world of asset classes is just as complicated as taking vitamins. How much should you take of small caps? Intermediate bonds? Emerging market stocks?
Stock AnalysisPepsiCo has long been known as one of the most resilient stocks throughout the broader market. Is this still the case today?
Mutual Funds & ETFsTarget-date funds are a popular way to invest for retirement. Here's what they can teach the novice investor.
ProfessionalsStock and bond markets are moving more closely in tandem with each other. Is illiquid real estate the vaccine for this correlation?
There are some types of mutual funds, called stock funds or equity funds, which hold only stocks. However, there are a number ... Read Full Answer >>
The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
Some mutual funds pay interest, though it depends on the types of assets held in the funds' portfolios. Specifically, bond ... Read Full Answer >>
Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
Depending on the specific assets in its portfolio, a mutual fund may generate income for shareholders in the form of capital ... Read Full Answer >>
A hedge fund manager does not necessarily need any specific license to operate a fund, but depending on the type of investments ... Read Full Answer >>