An Introduction to Asset Allocation

When you approach your financial planner, a term that most of you might have heard from him/her would be "asset allocation." In this article, you will learn about asset allocation, the importance of asset allocation, different asset allocation strategies and the benefits of asset allocation in portfolio management.

What Is Asset Allocation?

Asset allocation is one of the most important steps in your portfolio management process. The initial step for the financial planner is to determine your required rate of return based on your financial goals, risk tolerance and time horizon. The second step is to ascertain capital market expectations, as well as the expected return and expected volatility of each asset classes.

There are two categories of asset classes:

1. Traditional asset classes include stocks, bonds, and cash
2. Alternative asset classes include mutual funds, commodities, real estate, private equity, hedge funds

The third step is asset allocation, in which the financial planner develops a strategy of how much money to invest in each asset class for you to achieve your return objective at a risk level that you are able and willing to accept. The premise of asset allocation is that each asset class has a different risk and return characteristic, thus providing the investor with risk diversification benefits. (For related reading, see: Which Investor Personality Best Describes You?)

For instance, a 20% stock / 80% bond portfolio will provide lower risk and return and a more regular cash flow than an 80% stock/20% bond portfolio. It is also important to note that the latter is a riskier portfolio and is more suitable for young individuals in their twenties who have a longer time horizon and can tolerate stock market volatility. On the other hand, the first portfolio is more suitable for individuals who are nearing retirement and cannot withstand a drastic decline in their portfolio.

Why Is Asset Allocation Important?

As explained above, the most significant benefit of asset allocation is that it provides diversification and helps the investor manage the risk of his/her portfolio. While most people do understand this concept, they would still focus on which investment would outperform or whether equity markets would trend up or down. Although these are important considerations, many professional money managers believe that asset allocation is the most important decision for the investors. (For related reading, see: Why You Should Diversify and Rebalance.)

According to Sheryl Rowling, a certified public accountant and principal at Rowling & Associates, with asset allocation strategy "you have different pieces of the pie, and all those pieces react differently to different occurrences in the market." She added, "Some pieces go up while other pieces go down, so you will still get the average return of the market, but you won't have the extreme ups and downs."

What Are Different Asset Allocation Strategies?

As previously mentioned, the most important factors in determining the asset mix are risk tolerance and time horizon. An individual with a longer time horizon and higher risk tolerance should automatically tilt his or her portfolio toward stocks. According to a traditional rule of thumb, the percentage of stock allocation should be equal to 100 minus your age. So if your age is 25, then 75% of the portfolio should be allocated toward stocks. Over the years, many experts have expressed concern over using this rule as they believe it results in extremely conservative portfolios for retirees.

Also, following the aforementioned rule deprives an individual of venturing into other asset classes other than stocks and bonds. For instance, during high inflation, stocks, bonds, as well as cash and cash equivalents tend to underperform. To combat inflation (in financial terms we can say to hedge inflation risks), individuals can invest their money in real estate and commodities to achieve low variability in their portfolio returns.

Therefore, it is important to take a holistic approach in developing an asset allocation strategy. Here are two types of asset allocation strategies:

1. Strategic asset allocation: This strategy is a disciplined approach that involves assigning weights to different asset classes on the basis of an investor's risk and return objectives and the capital market expectations. It is based on Modern Portfolio Theory, which assumes that every investor is rational and shows risk aversion (i.e. desire for high returns with the lowest possible risk). Every financial planner would customize this strategy according to your needs and factor it in your financial plan. This is also called a "policy portfolio." The financial planner would also assign a maximum permissible range for each asset class, e.g., if stocks have an allocation of 50% in your policy portfolio, the financial planner can assign a permissible range of 46% to 54% for your stock allocation. This means that any time the stock percentage ventures outside this range, your portfolio will have to be rebalanced. If it goes below 46%, then you will buy additional stocks and if it goes above 54%, you will have to sell stocks. (For related reading, see: Diversification and Lessons from a Normalizing Market.)
2. Tactical asset allocation: While strategic asset allocation is implemented over the long term, tactical asset allocation allows investors to make short-term deviations from asset weights assigned in strategic asset allocation strategy. These short-term deviations are achieved by implementing a moderately active strategy. For example, your financial planner expects domestic stocks to outperform in the future as the Federal Reserve is about to announce rate cuts. He/she may ask to take out money from cash and cash equivalents and invest more money in domestic stocks for six months. However, the portfolio will return to the strategic asset mix after six months.

The Bottom Line

Asset allocation is the most important part of the portfolio construction process. It can be strictly passive in nature or can become a very active process. The asset mix decision heavily depends on an individual's age, risk tolerance, goals, time horizon and capital market expectations. It is important to note that an asset mix for one person may be completely inappropriate for another.