Why does a portfolio need dynamic asset allocation?

Dynamic asset allocation combines the unique benefits of different asset classes based on market valuation

Why does a portfolio need dynamic asset allocation?

Dynamic asset allocation is a portfolio-management strategy wherein the mix of asset classes is frequently adjusted to suit market conditions. Adjustments typically involve reducing positions in the worst-performing asset classes while adding to positions in the best-performing assets.

Dynamic asset allocation’s general premise is to respond to current risks and downturns and capitalize on trends to achieve returns exceeding a targeted benchmark like the S&P 500. There is usually no target asset mix, as investment managers can adjust portfolio allocations as they see fit. The success of the asset allocation lies with the portfolio manager’s ability to make the right investment decisions at the right time.

Why should investors consider using dynamic asset allocation?
One major advantage is optimal performance. Investing in the best-performing asset classes ensures that investors’ portfolios have the highest exposure to the momentum and reap the returns if the trend persists. It also helps minimize losses when reducing asset classes that are trending lower.

Another major advantage is diversification. Dynamic asset allocation exposes a portfolio to multiple asset classes to help mitigate risk. Portfolio managers may invest in currencies, derivatives, equities, fixed interest, index funds, and mutual funds. If the manager makes a wrong decision, best-performing asset classes can help make up for underperforming assets.

Dynamic asset allocation registers a higher return-risk ratio than an equity-only strategy on account of much lower volatility due to diversification. The former is also believed to witness lower drawdowns than the latter. Drawdown refers to the peak-to-trough decline during a specific period of investment that is reported in percentage terms.

Aside from these, dynamic asset allocation is often cheaper than active trading. It can have tax benefits if the Canada Revenue Agency (CRA) taxes long-term capital gains at a lower rate than short-term capital gains. The former also requires less in trading commissions and advisory fees, which often force investors to have higher-return requirements to compensate for these extra costs.

Ultimately, a dynamic asset allocation strategy is a mix of active and passive investing. On one hand, investors can keep a consistent, long-term asset allocation and do not need to alter that based on short-term market swings or stock fads. On the other hand, they can occasionally buy and sell securities in their portfolio to keep the portfolio aligned with the original weightings.

How does dynamic asset allocation work?
For instance, an investor allocates 50% of the portfolio to stocks, 30% to bonds, 10% to real estate and 10% to cash. As time passes by, the stocks in the portfolio might rise in value significantly enough that the stock weighting increases from 50% to 70% and, in turn, reduces the proportion of the other asset classes in the portfolio. Under this circumstance, the investor might sell a portion of the stocks or buy securities in other asset classes to bring the portfolio back to the original weighting.

What investment principles should investors consider?
One of the principles investors should keep in mind is that risk and volatility are not the same. Risk is the potential to lose money, while volatility is a backward-looking measure at how variable an asset is.

In dynamic asset allocation, there is often a greater risk when investing in high-performing assets with low volatility than in low-performing assets with high volatility. This is due to the role investor expectation plays. Expectations on high-performing assets become increasingly hard to meet, while expectations on low-performing assets become easy to meet.

Another principle to consider is that diversification based on historical correlation can be destructive. Correlations can change, usually increasing during economic instability. When the economy turns and investors decide to sell at the same time, overcrowding and the high pricing of popular investments will lead to high correlation. Thus, the diversification benefits that are crucial during these times are not received.

Rather than relying on historical correlation, diversification can be based on how assets are valued and how crowded the positioning is.

Another thing to keep in mind is that market cycles (which range from multi-year to multi-month periods) lead the economic cycle. If investors aim to buy assets when the economic cycle is strong and sell them when it is weak, they will likely miss out on opportunities and be exposed to risks. History has proven that weak economic conditions do not always lead to weak future share market returns.

There is seldom a single investment strategy that can consistently outperform other strategies in all market conditions. Investment decisions often involve finding the right balance between various asset classes through unpredictable market conditions. And dynamic asset allocation does that – it provides a rule-based mechanism that intends to combine the unique benefits of different asset classes based on market valuation. This strategy is ideal for investors seeking stable risk-adjusted returns with lower drawdown over long-term investment horizons.