Strategic asset allocation is one method of allocating your investment. Asset allocation strategy, in general, is an investment method that aims to balance risk and return. Investors allocate their assets based on their risk tolerance, return goals, and long-term investment plans. Each asset class has its own risk level and return rate. Hence their allocation varies from each other.
In this article we will explore the strategic asset allocation in the following:
- What is strategic asset allocation?
- How strategic asset allocation works?
- Things to consider for strategic asset allocation
- Why is strategic asset allocation important?
- The difference between strategic and tactical asset allocation
- Do you need strategic asset allocation?
What is strategic asset allocation?
Strategic asset allocation[1] definition wise, is a long-term investment portfolio strategy where investors decide on an allocation method and stick to it for a long time rather than reacting to current market conditions. It is based on modern portfolio theory [2] and is used to diversify investment portfolios to generate higher returns with minimum risk. The investor allocates his money to various asset classes, like stocks, bonds, and cash, and only rebalances the portfolio when an asset class does well.
Understanding Strategic Asset Allocation
There is no ideal way to define strategic assets allocation and there are no hard and fast rules for calculating your asset allocation. However, it is common practice to start by determining your risk tolerance and timeframe for investing. Ask yourself, how much money can you afford to lose in the market? Do you prefer consistent returns with minimum risk, or are you ready to accept larger risks for higher rewards? How long do you intend to invest? These are just a few of the questions you'll have to answer before you begin the allocation process. Answering these questions honestly will aid you or your portfolio manager in understanding and determining how aggressively to invest in specific assets.
How strategic asset allocation works?
Strategic asset allocation strategy is similar to a buy-and-hold[3] scheme because investors decide on a plan and stick to it for a long time and only modifies it to rebalance it to its original allocation strategy. For example, if your target asset allocation is 70% equities and 30% bonds, and your investment, in reality, consists of 80% equities. Strategic asset allocation would require you to sell the extra 10% in equities and spread the profits in the lower performing asset class (like bonds, for example) even if your equities perform well. This is because your equity target is 70%, and hence it should remain in its original percentage. This is also called a contrarian approach[4].
Things to consider for strategic asset allocation
Strategic asset allocation considers the following factors which are intertwined with one another:
- Risk tolerance
- Return goals
- Investment time horizon
Both Risk and Reward goals have a major impact on strategic asset allocation. The more risk you can tolerate, the higher returns you can target. The same goes for lower risk tolerance and lower returns. If your objective is to maximise your profits for the long term, you can allocate more of your investment in high-risk and high reward asset classes like stocks. Investors with long-term targets are more like to invest in aggressive asset classes because the investor has the time to rebalance the risks with the rewards over the long term. The investor can even hold on during bad market conditions and need not cash out.
Strategic asset allocation example
Although strategic asset allocation is similar to a buy-and-hold strategy, it is nonetheless closely monitored. Portfolio rebalancing guarantees to make changes to the allocation after a predetermined period in order to bring the allocation to the main asset classes back to the level that was selected initially. This is necessary because the returns from different asset classes modify the asset allocation. Let's examine an example of strategic asset allocation:
- Initial Investment: Consider the case of an investor who has 100,000 EUR to invest. Let's assume his strategic asset allocation is 60% equities, 30% fixed income, and 10% cash. This means that 60,000 EUR will be invested in stocks, 30,000 EUR in bonds, and 10,000 EUR will be invested in cash and cash equivalents from the aforementioned investment pool. The frequency of rebalancing has been set at once a year
- Rebalancing: Let's assume that equity has returned 20%, fixed income has returned 10%, and cash has returned 1% after a year. The overall value of the portfolio has climbed to 115,100 EUR, with the equity, fixed income, and cash divisions valued at 72,000 EUR, 33,000 EUR, and 10,100 EUR, respectively. However, as a result of the change in value, the allocation of these asset classes has changed to 62.5%, 28.6%, and 8.7%, respectively, which is a departure from the initial 60:30:10 mix
- New investment: Given the increased value of the total portfolio, the value of the investment should be lower according to the initial asset allocation mix. This means that the extra profit from equities must be sold and the profits must be used to purchase more bonds and use the remaining to invest in cash to keep the original 60:30:10
Why is strategic asset allocation important?
Strategic asset allocation is significant in two ways. The first one regards portfolio design which depends on your time horizon and risk tolerance. As you will be focusing on a long-term passive investment with minimal risk, you will diversify your assets, where, in times of volatility, profits from one asset class can minimise the loss from another asset class, thereby reducing overall portfolio volatility. Because particular asset classes like equities can be volatile, other investments in a well-constructed portfolio will counteract them, bringing a more stable return pattern.
The second reason strategic asset allocation is crucial is that it allows investors to maintain a long-term view and avoid making rash decisions. Investors have a proclivity to chase the market's best-performing segments while avoiding the worst-performing ones. However, predicting which regions will continue to thrive and who will be the future industry leaders is extremely difficult. Trying to time the market can backfire, as evidenced by a Dalbar Associates analysis[5] which indicates that stock investors have averaged a 5% annualised return over the last 20 years while the benchmark has increased by 9.2%. In other words, by attempting to time when to purchase and sell, most investors missed over half of the favourable market performance. Furthermore, despite being in a higher-performing asset class, stock investors barely kept up with inflation.
When it comes to bond investors, who have consistently underperformed inflation and the overall bond market, this underperformance is even more pronounced.
The difference between strategic and tactical asset allocation
Tactical models[6] alter allocations based on anticipated market possibilities, whereas strategic models take a long-term view of investing. The comparison between strategic and tactical asset allocation often comes up due to their polar differences. Strategic asset allocation models a more passive investment management, while tactical asset allocation has an active portfolio management approach.
Strategic asset allocation vs tactical asset allocation
Strategic asset allocation process is for you if you prefer the following as your investment objectives:
- You prefer to be hands-off of your investment and not buy-sell regularly. You only buy or sell when you need to rebalance your portfolio
- You prefer only to buy assets that you want to keep for longer. This effectively reduces your transaction fees too
- If you do not need the money for a long time - in that case, you can hold it for a long time and recover from the potential market downfall
- Suppose you feel that you are not experienced enough to opt for active investments. In that case, strategic asset allocation will force you to stick to your original plans without exposing you to emotional trading
Tactical asset allocation strategy is for you if you prefer the following:
- If you want to have more control over your investment decisions
- If you want to trade more often to make greater profits from the market conditions. This will mean making more transactions and incurring higher fees
- If your investment goals are for a short term
- You feel confident enough to trade actively if you know how to utilise current market conditions more effectively to your advantage
It should be noted that most investors combine strategic and tactical asset allocation to take advantage of the investment opportunities for an increase in portfolio growth and to balance out the level of risk.
Do you need strategic asset allocation?
You have to make sure to choose an investment strategy that makes sense for you. Strategic allocation is suitable for you if you prefer long-term passive investments that are diversified and only get involved when you have to rebalance them. To determine whether you need strategic asset allocation, ask yourself, will you be okay without the money for a long time and are you comfortable with market volatility? If the answers to both questions are yes, then you may want to delve into strategic asset allocation.
It does, however, require discipline to follow the process. In a turbulent market climate, this can be difficult. Buying/selling equities to rebalance allocations back to strategic aims is common during market volatility and economic uncertainty. It also means minimising stock exposure during periods of good market returns, when investor sentiment is typically very positive about the economy and the financial markets' future prospects. The strategic asset allocation process can be derailed by short-term thinking and emotions.
How to achieve optimal asset allocation
The main goal of strategic asset allocation is to get the most out of the limited resources available, which translates to maximising returns while avoiding risk. When selecting how much to allocate to each asset class, take into account your age, risk profile, and investment horizon.
The investment portfolio is determined in part by the investor's age. When you're young, you have more time to let your investments recover in cases of loss. Furthermore, because the investment value is typically low in the early years of investing, the recovery is quicker. As you get older, it's a good idea to shift a larger percentage of your investments to safer assets like debt.
According to the thumb rule of investment, the equity exposure should be 100 minus the age. So, a 50-year-old investor should have 50% of his total investments in equities, whereas a 40-year-old may afford to have over 60% of his investment in equities. However, this isn't a hard and fast rule, and an individual's portfolio should represent his or her risk tolerance.
Summary
Strategic asset allocation is a method of investing that aims to achieve a balance between risk and return. It's comparable to a buy-and-hold strategy in that investors choose a strategy and stick to it for a long time, only changing it to rebalance it back to its initial allocation strategy. When allocating assets, investors evaluate risk tolerance, return targets, and long-term investing plans, among other things. Strategic asset allocation is important because it reduces the volatility of your portfolio overall and it focuses on the the long-term, thereby stabilising your investment. If you prefer to be hands-off from the investment, then strategic asset allocation is for you. If you prefer active management of your investment, then tactical asset allocation is more suitable for you.
Strategic asset allocation is ideal for anyone who is looking to be free from investment headaches. This type of investor wishes to buy few times a year and hold on to it until he is required to change it back to his original target. This investor may have the same risk tolerance their whole life, and it will rarely change on the market volatility. If you are this investor but unsure how to allocate strategically, better consult with a financial advisor to create an appropriate investment portfolio.
List of References
- Source: investopedia.com
- Source: forbes.com
- Source: investopedia.com
- Source: investopedia.com
- Source: content.rwbaird.com
- Source: investopedia.com
