Setting up an appropriate asset mix of stocks, bonds, cash and equivalents in an investment portfolio is a dynamic process. It plays a vital role in determining an investment portfolio’s overall risk and return. For this reason, the asset mix should reflect an investor’s goals at any given period.
In asset allocation, there is no fixed rule on how investors should invest, and financial advisors follow different approaches. Asset allocation can be active to varying degrees or strictly passive in nature. Yet, the following are the most commonly used asset-allocation strategies along with their basic management approaches:
Strategic asset allocation
Strategic asset allocation establishes and adheres to a base policy mix – a proportional combination of assets based on expected rates of return for each asset class. It generally implies a buy-and-hold strategy, even as the shift in values of assets causes a drift from the initially established policy mix.
Tactical asset allocation
In the long run, strategic asset allocation may seem relatively rigid. As such, investors may find it necessary to engage occasionally in short-term, tactical deviations from the mix to capitalize on exceptional or unusual investment opportunities. Tactical asset allocation, then, aims to maximize short-term investment strategies. This flexibility adds a market-timing component to the portfolio, enabling investors to participate in economic conditions more favourable for one asset class than for others.
Tactical asset allocation can be considered a moderately active strategy, since investors return to the overall strategic asset mix once the desired short-term profits are achieved. This strategy demands discipline, as investors 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.
Constant-weighing asset allocation
With this approach, investors continually rebalance their portfolio. For instance, if one asset is declining in value, they are to buy more of that. And if that asset value is rising, they are to sell it. A common rule for timing portfolio rebalancing under this asset allocation strategy is that the portfolio should be rebalanced to its original mix when any given asset class moves more than 5% from its original value.
Dynamic asset allocation
Using this strategy, investors can constantly adjust the mix of assets as markets rise and fall and as the economy strengthens and weakens. They can also sell assets that are declining and buy assets that are rising in value.
For this reason, dynamic asset allocation can be considered the polar opposite of a constant-weighing strategy. For instance, if the stock market is showing weakness, investors may sell stocks in the hope of further decreases; if the market is strong, they can buy stocks in the hope of continued market gains.
Insured asset allocation
With this strategy, investors set 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, they would be exercising active management – relying on analytical research, forecasts and judgment and experience to decide what securities to buy, hold or sell, with the aim of increasing the portfolio value as much as possible. If the portfolio should ever drop to the base value, they will need to invest in risk-free assets like Treasuries (especially T-bills) so that the base value becomes fixed. At that point, they will need to consult a financial advisor on reallocating assets, perhaps even changing their entire investment strategy.
Insured asset allocation may be best suited to risk-averse investors who want a certain level of active portfolio management but appreciate the security of establishing a guaranteed floor below which the portfolio is not allowed to drop. For instance, an investor who wishes to establish a minimum standard of living during retirement might find this strategy ideally suited to his or her management goals.
Integrated asset allocation
Using this approach, investors consider both their economic expectations and risk when establishing an asset mix. While all the other strategies mentioned above take into account expectations for future market returns, not all of them account for an investor’s risk tolerance. Integrated asset allocation, on the other hand, is a broader strategy. It includes all aspects of all strategies, accounting not only for expectations but also actual changes in capital markets and investor risk tolerance. However, take note that it cannot include both constant-weighing and dynamic allocation, which are two strategies that compete with one another.
The asset allocation strategies discussed above only serve as general guidelines on how investors can capitalize on asset allocation as part of their overall investment strategy. Ultimately, the decision is still in the hands of investors. Whether they choose a precise asset allocation strategy or a combination of different strategies will depend on different factors, such as their age, investment goals, market expectations and risk tolerance.