Asset allocation is the cornerstone of investment strategy. It involves dividing your portfolio among different asset classes to balance risk and reward. The goal is to maximize returns while minimizing risk, based on your personal financial situation and goals.

There are two main approaches: strategic and tactical. Strategic allocation sets long-term targets, while tactical makes short-term adjustments. Factors like risk tolerance, objectives, and time horizon shape these decisions. Regular rebalancing keeps your portfolio on track.

Asset Allocation Strategies

Strategic vs tactical asset allocation

• Strategic asset allocation
  • Long-term investment approach focusing on investor's risk tolerance, goals, and investment timeline
  • Sets target percentages for each asset class (stocks, bonds, cash)
  • Reviewed and rebalanced periodically (annually) to maintain desired allocation
• Tactical asset allocation
  • Short-term strategy aiming to capitalize on market opportunities or reduce risks
  • Temporarily deviates from strategic allocation targets
  • Requires active management and market timing decisions (overweighting sectors, underweighting regions)

Factors in allocation decisions

• Risk tolerance
  • Investor's ability and willingness to tolerate potential investment losses
  • Higher risk tolerance enables greater allocation to riskier assets (equities, commodities)
• Investment objectives
  • Specific goals such as preserving capital, generating income, or growing wealth
  • Allocation should match investor's objectives (income-focused, growth-oriented)
• Time horizon
  • Duration investor plans to hold the investment portfolio
  • Longer time horizons allow higher exposure to riskier assets (retirement savings)
• Market conditions
  • Prevailing economic environment, interest rates, and market valuations
  • May influence short-term tactical allocation decisions (defensive positioning)
• Liquidity needs
  • Investor's need to access funds from the portfolio
  • Greater liquidity requirements may necessitate larger cash or short-term holdings (emergency funds)

Rebalancing for portfolio targets

• Rebalancing
  • Adjusting portfolio's asset mix back to target allocation percentages
  • Required due to divergences in asset prices over time (stock market gains)
• Importance of rebalancing
  • Maintains intended risk profile of the portfolio
  • Prevents portfolio from drifting significantly from desired asset allocation
  • Helps manage overall portfolio volatility (selling high, buying low)
• Rebalancing strategies
  1. Periodic rebalancing on a fixed schedule (quarterly, annually)
  2. Threshold-based rebalancing when allocation deviates by a set percentage (5% bands)

Asset allocation strategy comparison

• Static asset allocation
  • Advantages
    • Straightforward to implement and maintain over time
    • Appropriate for investors with consistent risk profile and long-term goals
  • Disadvantages
    • May miss out on near-term market opportunities
    • Potentially lower returns vs more active management approaches
• Lifecycle (target-date) funds
  • Advantages
    • Automatically shifts asset allocation as investor nears target end date (retirement)
    • Streamlines investment decisions for the individual investor
  • Disadvantages
    • Standardized approach may not match every investor's unique circumstances
    • Typically charge higher fees than self-directed portfolios
• Dynamic asset allocation
  • Advantages
    • Flexibility to adapt to evolving market conditions
    • Potential to generate higher returns by capitalizing on market inefficiencies
  • Disadvantages
    • Demands active management skill and market timing ability
    • Incurs greater transaction costs and management fees
    • Introduces complexity and potential for manager mistakes