In our last article we discussed investment management, talking mainly about the pillars of investment management. We covered asset management, portfolio management, and stock selection and valuation. As you may already know, strategic asset allocation is an important part of investment management.
We have previously written about how to:
- practice asset allocation
- determine the best asset allocation for you based on your age
- apply asset allocation for foundations and endowments
Today, we’re going to be discussing the strategies behind asset allocation. In this article we will explain what exactly strategic asset allocation is and how it works. But most importantly, we’ll show what makes a strategic asset allocation effective for investors.
Why Asset Allocation?
Asset allocation is the investment strategy of stretching your investment portfolio around different asset categories.
Strategic asset allocation is actually one of several more specific asset allocation approaches. When practicing strategic asset allocation, the investor sets target allocations for different asset classes. So, when their allocations end up straying from the original way they were set up due to varying levels of return, the investor will rebalance their portfolio.
So how do you, the investor, decide what your target allocations will be?
Personalizing your portfolio
Several factors typically go into deciding on your target allocations, and they are all deeply personal.
Investors generally consider:
- the investment time frame they are looking at
- the level of risk they are willing to take on
- their overarching investment goals and objectives
These are all very subjective, personal factors. And as such the ways in which investors choose to translate their feelings about these criteria into strategic asset allocation can be quite varied.
The important part is that you take these factors into consideration. And then based upon your desired time horizon, risk tolerance, and investment approach, you would create a proportional allocation across various asset classes.
However, returns from those asset classes will inevitably deviate from what you thought they would be. At this point, you take into account the three factors above and rebalance your asset allocation strategy.
More Options for Allocation Strategies
Tactical asset allocation
There are several other asset allocation strategies, but the most notable is tactical asset allocation. Tactical asset allocation is a much more flexible, active approach to asset allocation and management. It is also a short-term asset allocation strategy, whereas strategic asset allocation focuses on the long-term.
Tactical asset allocation is known as an active management strategy. Its purpose is for the investor to jump on appealing investment opportunities as they appear in the marketplace.
By contrast, strategic asset allocation employs a buy and hold strategy. This method is more focused on — you guessed it — researching, buying, and then holding specific assets, instead of jumping on new investment opportunities.
Another difference between the two is that tactical asset allocation is more focused on investing in small cap companies. Strategic asset allocation leans towards large cap companies. Small cap companies are those whose outstanding share market value is relatively small. Meanwhile, large cap companies, or stocks, possess a comparably higher market capitalization. Small cap stocks may be desirable in terms of a tactical asset allocation strategy because they often provide a better investment opportunity.
Constant-weighting asset allocation
Another method worth noting constant-weighting asset allocation.
Constant-weighting asset allocation builds upon the concept of rebalancing your portfolio. Except, with a constant-weighing approach, the rebalancing is constant.
So, instead of waiting to see how things shake up and then eventually rebalancing your portfolio, constant-weighing asset allocation calls for continually rebalancing it based upon what happens in the market. If one asset depreciates, an investor employing a constant-weighting strategy would fix that right away by buying more of the asset.
Dynamic asset allocation
Another common approach to asset allocation is dynamic asset allocation. Dynamic asset allocation is more similar in concept to tactical than strategic asset allocation. It relies significantly more on the portfolio manager’s judgment and personal feelings than a pre-determined, targeted balance of assets.
Dynamic asset allocation consists of constantly adjusting your asset classes. As the market shifts and assets change, dynamic asset allocation gives you the freedom to sell old assets and buy new ones.
It is worth noting that dynamic asset allocation is almost perfectly different from constant-weighting asset allocation. Constant-weighting asset allocation involves constantly reviewing your personal asset class settings. Meanwhile dynamic asset allocation is based on the behavior of the market and overall economy.
Insured asset allocation
With insured asset allocation, the portfolio manager establishes a baseline value below which they will not allow their portfolio to drop. If the portfolio does drop below its determined baseline value, the portfolio manager should invest in risk-free assets to bring the value back to baseline.
But while the portfolio is above baseline, the investment manager employs an active management strategy. In doing so, they decide which assets to invest in based upon personal needs, risk tolerance, and market research and behavior.
Integrated asset allocation
As the name implies, integrated asset allocation takes into account several different strategies of asset allocation. The investor considers both their expectations of return on investments and tolerance for risk.
If the above strategies all seem too specific for you, then integrated asset allocation is the way to go. It allows investors to pay attention to market behavior, while always coming back to the important question of how much risk they are willing to take on.
The Advantages of Strategic Asset Allocation
With all of these different strategies in mind, it seems difficult to know which fits you the most. So, we want to spend some time discussing why, or why not, you as a portfolio manager might want to pursue a strategic asset allocation strategy.
Less active involvement
First, a major factor to consider is the amount of time and energy that you are willing and able to put into portfolio management and asset allocation. If you are looking for a more hands-off approach, then strategic asset allocation may be right for you.
Unlike some of the other, more active and dynamic asset allocation management styles discussed above, strategic asset allocation does not require that you constantly reassess and rebalance your portfolio. You have to check in on it and occasionally rebalance it, of course. But for the most part, you are putting in some time upfront to set up your asset classes, and then letting the market do its work.
Another major reason to go with a strategic asset allocation approach over say, a tactical asset allocation approach is if you are looking for a long-term asset allocation strategy.
If you have a short time horizon, you may be tempted to pursue a more active portfolio management strategy, and that probably makes more sense for you. But if you have the luxury of having a reasonable amount of time before you need to cash in on your assets, strategic asset allocation may well be very appealing.
It gives the investment manager a built-in window of time in which to let the market and the economy ebb and flow as they inevitably will. Of course during this time, your assets may drop at times, but will presumably recover from any losses they may undergo.
Less experience needed
Strategic asset allocation also tends to be attractive to investors who may not have many years of experience managing portfolios. This is not to say that it is easy or doesn’t require research, but rather that it doesn’t necessarily require the grueling analysis and insight into market trends and the stock market that other forms of asset allocation strategies may necessitate.
We Can Help
There are few things that affect as many areas of your life as your wealth. Thinking about retirement, estate, or financial planning? Or will you use your wealth to provide for legacy or charitable purposes? Proper wealth management is what will make it happen. And an investment adviser is the right person to help.
At Saddock Wealth, our years of wealth management experience can help guide you toward financial prosperity. Schedule a meeting here, and we’ll discuss your best options.