By Aniket Bose. Edited by Arjun Chandrasekar.
An asset allocation is primarily the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio. Some categories of these investment portfolios include stocks, bonds, and cash. It works best on your ability to take risks.
There are five types of asset allocations: Strategic, Constant-Weighting, Tactical, Dynamic, Insured, and Integrated. Let’s go in much more detail for each one.
Strategic Asset Allocation
This asset allocation is a portfolio strategy whereby the investor sets target allocations for various asset classes and rebalances the portfolio at a fixed time. The target allocations are based on factors like the investor’s risk tolerance, time horizon, and the objectives of the investment. It gives your investments a purpose and determining a strategic asset allocation ultimately forces you to have a plan and constantly think about the purpose of your investment portfolio. It is more of a long term asset allocation compared to the tactical asset allocation and it is also commensurate to the investor’s risk profile. Having a strategic asset allocation increases the chances of reaching your goal as an investor.
Constant-Weighting Asset Allocation
This asset allocation can be defined as a type of asset allocation approach in which rebalancing occurs automatically. Several mutual funds permit rebalancing when they are established. For example, if an investor holds a portfolio amounting to about 70% stock in the US, 20% stock on the international market, while the rest is taken up by bonds and the value surges to 35% by value of stock, the fund would act quickly to rebalance by disposing international stock and acquiring bonds. Many investors prefer this approach because then their stocks are always protected against the slow response to market trends. However with strategic asset allocations, an investor may not realize gains enjoyed by other investors; however the investor will stay protected against loss.
Tactical Asset Allocation
This asset allocation is a dynamic investment strategy that actively adjusts a portfolio’s asset allocation. The goal of a tactical asset allocation is to improve the risk-adjusted returns of passive management investing. It shifts the asset allocations in a portfolio to take advantage of macroeconomic conditions. This strategy can be used to increase returns on investments, adapt to the current market conditions, and provide diversification. It is more in sync with the external factors rather than investment goals and the investor’s risk profile.
Dynamic Asset Allocation
This asset allocation is a strategy used by investment products such as hedge funds, mutual funds, credit derivatives, index funds, principal protected notes and other structured investment products to achieve exposure to various investment opportunities and also provide 100% principal protection. It is a portfolio management strategy that frequently adjusts the mix of asset classes to suit the market conditions. The adjustments usually involve reducing positions in the worst-performing asset classes while adding to positions in the best-performing assets. The general premise of a dynamic asset allocation is to respond to current risks and downturns and take advantage of trends to achieve returns that exceed a targeted benchmark. The success of this asset allocation depends on the portfolio manager making good investment decisions at the right time. For example, if the portfolio was initially equities heavy, the manager may sell some of its equity holdings and purchase bonds. If economic conditions improve, the manager may increase the portfolio’s equity allocation to take advantage of a more bullish outlook for stocks.
Integrated Asset Allocation
This asset allocation is concerned with the optimization of an investor’s net worth. It thus deals with expected net worth (which are assets with less liabilities) and standard deviation of future net worth, given the investor’s willingness to take on added net worth risk in order to increase the expected net worth. Integrated asset allocation provides a framework for viewing the key elements of the important asset allocation decision. The process of an integrated asset allocation involves major steps. First, the investor’s current net worth is transformed, via a risk tolerance function, into the investor’s risk tolerance. At the same time, current capital market conditions: prices, earnings, and dividends are transformed (by a complicated process) into expected returns, risks and correlations for various asset classes. Given these predictions and the investor’s risk tolerance, an “optimizer”(reducing the cost while improving the performance) determines the most appropriate asset mix. The mix determines actual returns to the investor over a time period. These returns feedback, from the investor’s net worth and capital market conditions, into the next period’s allocation procedure.