Asset Allocation

What is Asset Allocation?

Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals and investment time frame. The focus is on the characteristics of the overall portfolio. Such a strategy contrasts with an approach that focuses on individual assets.

The purpose of asset allocation is to maximize returns and minimize risk.

What Does Asset Allocation Mean?

What is the definition of asset allocation? In laymen’s terms, this refers to the process of carefully weighing out the positives and negatives of certain investments and adjusting investment strategy in such a way that helps grant the highest outcome in one’s portfolio. There are three different types of asset types and they are: equities, fixed-income, and cash and equivalents.

Businesses typically factor asset allocation into their overall investment strategy based on the amount of risk they are willing to incur, their preferred timetable as well as long-term investment goals. They employ several different techniques to maximize asset location ranging from diversification of investments to equitable distribution of resources devoted to equities, fixed-income, and cash investments.

In some cases, businesses employ a holding strategy, which dictates that, the entity hold a stock for a period of a few years or longer. Typically, this is how most investments are made. However, firms seeking a shorter-term return on investment may pursue an alternative strategy that grants returns within a couple of years.

Example

An investor named John has a stock portfolio worth 100 million USD which reflects a near equitable allocation of assets among equities, fixed-income, and cash holdings (33.3%). After a year, John sees that he has made a total of 20 million USD from equities, 10 million from fixed-income investments and another 5 million from cash holdings. John’s total growth after a year would be 35 million, which is a 35 percent increase from the preceding year.

However, John’s portfolio now represents an uneven balance because there is now a greater proportion of his invested assets placed in equities than fixed-income and cash holdings. John compensates for this by taking the excess 35 million USD and reinvesting it in his asset classes in an equitable fashion, in a process called ‘rebalancing’, so that his stocks reflect the same distribution percentage as they originally did (33.3%).

Why Asset Allocation Is Important?

There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, the selection of individual securities is secondary to the way that assets are allocated in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results.

Investors may use different asset allocations for different objectives. Someone who is saving for a new car in the next year, for example, might invest her car savings fund in a very conservative mix of cash, certificates of deposit (CDs) and short-term bonds. Another individual saving for retirement that may be decades away typically invests the majority of his individual retirement account (IRA) in stocks, since he has a lot of time to ride out the market’s short-term fluctuations. Risk tolerance plays a key factor as well. Someone not comfortable investing in stocks may put her money in a more conservative allocation despite a long time horizon.

Asset Сlasses

An asset class is a group of economic resources sharing similar characteristics, such as riskiness and return. There are many types of assets that may or may not be included in an asset allocation strategy.

Traditional assets

The “traditional” asset classes are stocks, bonds, and cash:

  • Stocks: value, dividend, growth, or sector-specific (or a “blend” of any two or more of the preceding); large-cap versus mid-cap, small-cap or micro-cap; domestic, foreign (developed), emerging or frontier markets
  • Bonds (fixed income securities more generally): investment-grade or junk (high-yield); government or corporate; short-term, intermediate, long-term; domestic, foreign, emerging markets
  • Cash and cash equivalents (e.g., deposit account, money market fund)

Allocation among these three provides a starting point. Usually included are hybrid instruments such as convertible bonds and preferred stocks, counting as a mixture of bonds and stocks.

Alternative assets

Other alternative assets that may be considered include:

  • Commodities: precious metals, nonferrous metals, agriculture, energy, others.
  • Commercial or residential real estate (also REITs)
  • Collectibles such as art, coins, or stamps
  • Insurance products (annuity, life settlements, catastrophe bonds, personal life insurance products, etc.)
  • Derivatives such as long-short or market neutral strategies, options, collateralized debt, and futures
  • Foreign currency
  • Venture capital
  • Private equity
  • Distressed securities
  • Infrastructure
  • Hedge funds

Asset Allocation Strategy

There are several types of asset allocation strategies based on investment goals, risk tolerance, time frames and diversification. The most common forms of asset allocation are: strategic, dynamic, tactical, and core-satellite.

Strategic asset allocation

The primary goal of strategic asset allocation is to create an asset mix that seeks to provide the optimal balance between expected risk and return for a long-term investment horizon. Generally speaking, strategic asset allocation strategies are agnostic to economic environments, i.e., they do not change their allocation postures relative to changing market or economic conditions.

Dynamic asset allocation

Dynamic asset allocation is similar to strategic asset allocation in that portfolios are built by allocating to an asset mix that seeks to provide the optimal balance between expected risk and return for a long-term investment horizon. Like strategic allocation strategies, dynamic strategies largely retain exposure to their original asset classes; however, unlike strategic strategies, dynamic asset allocation portfolios will adjust their postures over time relative to changes in the economic environment.

Tactical asset allocation

Tactical asset allocation is a strategy in which an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for perceived gains. While an original asset mix is formulated much like strategic and dynamic portfolio, tactical strategies are often traded more actively and are free to move entirely in and out of their core asset classes.

Core-satellite asset allocation

Core-satellite allocation strategies generally contain a ‘core’ strategic element making up the most significant portion of the portfolio, while applying a dynamic or tactical ‘satellite’ strategy that makes up a smaller part of the portfolio. In this way, core-satellite allocation strategies are a hybrid of the strategic and dynamic/tactical allocation strategies mentioned above.

Summary

Define Asset Allocation: Asset allocation means a method of minimizing investment risk through diversification.

  • Asset allocation is very important to create and balance a portfolio.
  • All strategies should use an asset mix that reflects your goals and should account for your risk tolerance and length of investment time.
  • A strategic asset allocation strategy sets targets and requires some rebalancing every now and then.
  • Insured asset allocation may be geared to investors who are risk-averse and who want active portfolio management.

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