Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame. In other words, it is an investment strategy that aims to balance risk and reward b apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon.
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, your selection of individual securities is secondary to the way you allocate your investment in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results. Asset allocation is based on the principle that different assets perform differently in different market and economic conditions. A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return.
*Brinson, Singer & BeeBower “Determinants of Portfolio performance: An Update,” Financial Analysts Journal, June ’91
Asset Allocation Strategies:
There are several types of asset allocation strategies based on investment goals, risk tolerance, time frames and diversification: strategic, tactical, and core-satellite.
- Strategic Asset Allocation: is a portfolio strategy that involves periodically re-balancing the portfolio in order to maintain a long-term goal for asset allocation. The primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon. At the inception of the portfolio, a “base policy mix” is established based on expected returns. Because the value of assets can change given market conditions, the portfolio constantly needs to be re-adjusted to meet the policy.
- Tactical Asset Allocation: is a portfolio 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 gains. In other works, Tactical asset allocation is a dynamic investment strategy that actively adjusts a portfolio’s asset allocation. The goal here is to improve the risk-adjusted returns of passive management investing.
- Core-Satellite Asset Allocation: is more or less a hybrid of both the strategic and tactical allocations mentioned above. In this strategy, the portfolio is broken up into two parts – Core & Satellite. Typically, the core part is more long term in nature and a strategy asset allocation policy is likely to be followed. For satellite part, typically a more active and aggressive stance is taken and it is likely that tactical asset allocation is followed that provides flexibility to change assets as per market conditions.