What is Strategic Asset Allocation
Strategic asset allocation is a portfolio strategy that involves setting target allocations for various asset classes and rebalancing periodically. The portfolio is rebalanced to the original allocations when they deviate significantly from the initial settings due to differing returns from the various assets.
Strategic Asset Allocation to Rebalance Portfolios
BREAKING DOWN Strategic Asset Allocation
In strategic asset allocation, the target allocations depend on several factors, such as the investor’s risk tolerance, time horizon, and investment objectives, and may change over time as these parameters change. Strategic asset allocation is compatible with a buy-and-hold strategy, as opposed to tactical asset allocation that is more suited to an active trading approach. Strategic and tactical asset allocation styles are based on modern portfolio theory, which emphasizes diversification to reduce risk and improve portfolio returns.
Strategic Asset Allocation Example
Suppose 60-year-old Mrs. Smith, who has a conservative approach to investing and is five years away from retirement, has a strategic asset allocation of 40% equities / 40% fixed income / 20% cash. Assume Mrs. Smith has a $500,000 portfolio and rebalances her portfolio annually. The dollar amounts allocated to the various asset classes at the time of setting the target allocations would be equities $200,000, fixed income $200,000 and cash $100,000.
In one year’s time, suppose the equity component of the portfolio has generated total returns of 10%, while fixed income has returned 5% and cash 2%. The portfolio composition is now: equities $220,000, fixed income $210,000 and cash $102,000.
The portfolio value is now $532,000, which means the overall return on the portfolio over the past year was 6.4%. The portfolio composition is now: equities 41.3%, fixed income 39.5% and cash 19.2%.
Based on the original allocations, the portfolio value of $532,000 should be allocated as follows: equities $212,800, fixed income $212,800 and cash $106,400. The table below shows the adjustments that must be made to each asset class to get back to the original or target allocations.
Thus, $7,200 from the equity component has to be sold to bring the equity allocation back to 40%, with the proceeds used to buy $2,800 of fixed income and the balance of $4,400 allocated to cash.
Note that while changes to target allocations can be carried out at any time, they are done relatively infrequently. In this case, Mrs. Smith may change her allocation in five years, when she is on the verge of retirement, to 20% equities, 60% fixed income and 20% cash, to reduce portfolio risk. Depending on the portfolio value at that time, this would necessitate significant changes in the composition of the portfolio to achieve the new target allocations.