The Role of Strategic Asset Allocation in Your Investment Portfolio

Strategic asset allocation is a financial strategy designed to help you discern the ideal proportion of your assets to be allocated to stocks, bonds, and cash. Once this allocation is determined, it remains consistent over an extended period.

Major Points

·         Strategic asset allocation is a financial strategy that assists in determining the distribution of your assets across stocks, bonds, and cash.

·         Once an allocation is set, it is held constant over a long period, regularly evaluated, and rebalanced when needed.

·         Strategic asset allocation adopts a more passive investment approach compared to tactical allocation which requires active portfolio management.

·         Many investors utilize a combination of both strategic and tactical asset allocation strategies.

Strategic asset allocation is a crucial technique in the investment landscape, providing a structured plan for dividing your assets across multiple investment categories such as stocks, bonds, and cash. This strategy calls for a firm commitment to the predetermined allocation over a significant duration. It advocates periodic reviews of the portfolio, making adjustments to the allocation when necessary, to maintain the balance between various asset classes.

Strategic asset allocation largely supports a passive approach to investing, which aims to mirror the market returns. This contrasts with the active management model, such as in tactical asset allocation, where the investor makes deliberate shifts in their portfolio based on short-term market forecasts. Although these two strategies are distinct, many investors often blend them, seeking the benefits of both passive and active investment management.

Delving Deeper into Strategic Asset Allocation

Numerous asset allocation models exist, each hinging on risk tolerance. If you're unsure about which mix of investments to choose and in what proportions, various online tools can assist you. Alternatively, you can consult a financial professional for more customized advice. Whether you use an online questionnaire or calculator, or seek advice from a financial consultant, all these resources aim to gauge your comfort level with risk, which then helps formulate an appropriate asset allocation.

As an illustration, if you possess a high risk tolerance and a long investment horizon, an allocation recommendation might suggest a distribution of 70% stocks, 20% bonds, and 10% cash. A more conservative approach might propose a 60% stocks and 40% bonds allocation. These are popular models, often referred to as a “70/20/10” portfolio or a “60/40” portfolio.

Typically, the greater your risk tolerance, the more aggressive your investment strategy can be, implying that you could invest more funds into stocks if your primary objective is maximizing long-term growth.

The Foundation of Modern Portfolio Theory

The concept of strategic asset allocation is fundamentally rooted in Modern Portfolio Theory (MPT). This theory asserts that markets are efficient and exhibit patterns that are more reliable than the speculative predictions of individual investors.

MPT discourages the attempt to "beat the market" through frequent trading and speculation. Instead, it suggests taking advantage of the market's inherent efficiency by holding a diversified portfolio of assets with varying degrees of risk and return. This balance helps optimize the potential for returns while minimizing exposure to market volatility.

Strategic Asset Allocation in Action

A range of asset allocation models is available, all tailored to different levels of risk tolerance. Many online tools and financial advisors can help you determine the right blend of investments based on your comfort with risk, creating an appropriate strategic asset allocation for your specific needs.

For example, if you have a high-risk tolerance and a long investment horizon, you may be guided towards an allocation of 70% in stocks, 20% in bonds, and 10% in cash. On the other hand, if you have a moderate risk tolerance, you might be advised to follow a 60/40 allocation strategy, with 60% in stocks and 40% in bonds. These are commonly referred to as a “70/20/10” or “60/40” portfolio, respectively.

Preserving Your Asset Allocation

Once you decide on an asset allocation strategy, it's essential to maintain it. You should regularly assess your portfolio to ensure it remains aligned with your asset allocation strategy. You may want to consider rebalancing it on a set schedule (e.g., annually) to ensure that any deviation from the original allocation is corrected.

For example, if your target asset allocation is 60% stocks and 40% bonds, but stocks currently make up 70% of your portfolio, you should sell the surplus 10% in stocks—even if stocks are performing well currently—and reinvest the proceeds into bonds to bring your stock allocation back to the targeted 60%. This action exemplifies the strategic asset allocation approach's principle of adhering to your initial plan rather than responding to current market trends, with the belief that it will yield long-term benefits.

However, if you receive information that necessitates a change in the allocation itself, altering it and then sticking to the new allocation is acceptable. This change should be based on a shift in your personal comfort with taking on more (or less) risk, not merely a change in asset performance or market trends.

Comparing Strategic and Tactical Asset Allocation

Strategic asset allocation follows a more passive investment approach, while tactical asset allocation adopts a more active approach. The method that best suits you depends on your investment style.

Strategic Asset Allocation vs. Tactical Asset Allocation:

Strategic Asset Allocation: Offers a hands-off approach with a buy-and-hold strategy. It works well for long-term time horizons and is suitable for novice investors. It's also better suited for investors prone to emotional decisions.

Tactical Asset Allocation: Provides greater control and involves frequent trading. It's well-suited for short-term or medium-term time horizons and demands a higher level of investment expertise. It also requires the ability to control impulse trading.

Effectiveness of Strategic Asset Allocation

A strategic asset allocation strategy may be the right choice for you if:

• You prefer a hands-off approach: This approach allows you to buy investments in a specific mix and only rebalance them when the allocation deviates from that mix.
• You prefer to buy and hold: You will buy investments and hold onto them over the long term. This means you seldom need to move money around or incur associated transaction fees.
• You have a long investment horizon: The longer your investment period, the more attractive this method becomes. This is because there is ample time for the market to recover from potential downturns. You have limited investment experience: This method requires research but doesn't demand in-depth insights into market trends. It may be an excellent choice if you don't have the experience needed to react to ongoing market events.
• You're an emotional investor: Strategic asset allocation forces you to adhere to your initial asset allocation, irrespective of market fluctuations. If you're an impulsive shopper or prone to panic buying (or selling), strategic asset allocation can help prevent reckless trades.

Effectiveness of Tactical Asset Allocation

A tactical asset allocation approach might be suitable for you if:

• You desire more control: If you have little faith in market forces directing your investments and prefer to control your trades while retaining the ability to make independent trading decisions, this strategy could be a better fit.
• You're willing to trade frequently: Contrary to a buy-and-hold strategy, a trading approach doesn't necessarily adhere to original investment choices over several years. Instead, you continually monitor your investments and seize investment opportunities as they arise, potentially leading to more frequent transactions and higher transaction fees.
• You have a short- to medium-term investment horizon: A tactical approach might be more appropriate for funds in a regular investment account aimed at short-term growth rather than a long-term, defined goal.
• You possess more expertise: If you have considerable market insights and know how to judiciously react to changes, this option might work for you. However, there are no guarantees of superior results compared to a strategic asset allocation approach.

Many financial managers use a mix of strategic and tactical asset allocation to enhance both the stability and flexibility of their funds.

Is Strategic Asset Allocation Necessary?

Your investment strategy will be influenced by several factors, including:

The timeline of your investment goals. Your risk tolerance. Your comfort level with making investment decisions.

Strategic asset allocation is ideal for the typical buy-and-hold investor who may lack extensive investment experience but prefers a hands-off approach to saving for a long-term goal like retirement. Investors who prefer to actively manage their investments over a shorter period should consider a tactical asset allocation strategy.

Your risk tolerance may remain constant throughout your life, implying that your comfort with volatile markets will stay the same as you age. However, as you approach the time to withdraw funds from an investment account, you may want to decrease your risk exposure, as there will be less time to recoup investment losses during a market downturn.

As an example, most investors transition to a more conservative investment allocation strategy as they near retirement, allocating more of their portfolio to bonds and less to volatile stocks.

If you're unsure whether strategic asset allocation is right for you, consider consulting a financial adviser.

How to Implement Strategic Asset Allocation

To create a portfolio that suits your investor profile, follow these steps:

Identify Your Risk Tolerance: This is the level of volatility you're willing to accept. If you can remain calm during market downturns, you can afford to be more aggressive by investing more in stocks. If market downturns make you anxious, you may want to adopt a more conservative investment strategy through more bonds or cash.

Consider Your Investment Timeline: How long do you plan to hold onto your investments? If you don't anticipate needing the money for an extended period, you can afford to be more aggressive. In general, the longer your investment horizon, the less bothered you should be by high volatility associated with more aggressive allocations.

Understand Your Investment Goals: Is your objective to achieve capital growth, fixed income, or a combination of the two? Growth generally demands a more aggressive investment allocation, while income necessitates a more conservative approach.

Determine Your Allocation: Asset classes include cash, bonds, or stocks. When deciding on the target percentage for each class, consider the long-term expected returns and risk level of each asset class. Stocks carry the most risk, followed by bonds, with cash being the least risky. Higher risk offers greater potential for growth and loss.

Break Down Each Asset Class: Stocks, for example, can be categorized into large-cap, small-cap, U.S., international, and emerging markets, among other sub-categories.

Develop an Allocation Plan: Assign a target percentage allocation for each underlying category. For example, allocate 10% to U.S. small-cap stocks.

Buy Funds: You can purchase numerous individual funds to achieve your planned allocation in total, or you can rely on a fund that does the work for you. For instance, you could buy a balanced mutual fund, which includes stocks and bonds in a single fund, usually at fixed percentages (like 60% stocks and 40% bonds). Many 401(k) plans also offer "model" portfolio allocations that simplify the process for you.