Strategic Asset Allocation

Strategic Asset Allocation is a specific plan of action for portfolio management which involves following a particular strategy and setting targets within asset classes, portfolio rebalancing, and checking the deviations from the initial levels of returns to make further adjustments/improvements.

Strategic Asset Allocation is an approach towards portfolio construction. It helps determine the allocation to asset classes considered for investment. The tolerance for risk and expectations of return are crucial in determining the optimal Strategic Asset Allocation for an investor. These, along with the investment horizon, are vital in shaping the allocation of a portfolio over time.

As opposed to Tactical Asset Allocation, which targets a short or medium-term investment horizon, Strategic Asset Allocation is a long-term decision, typically spanning a decade or more.

The asset classes are divided across levels, market caps and geographically. Broadly speaking, the three major asset classes are equities, fixed income, and cash. But they can be further subdivided. For instance, the overall allocation to equities can be divided across large, medium and small-cap stocks, or across geographies like Asia-Pacific and Latin America, or country-specific allocations to the US, the United Kingdom, Japan, among others. Analytical classifications like developed, emerging, and frontier markets can also be used to allocate the equity or fixed income portion of the portfolio.

Strategic Asset Allocation is based on Modern Portfolio Theory. Let’s briefly look at this basis and the relationship between the two.

Strategic Asset Allocation

Modern Portfolio Theory and Strategic Asset Allocation

Modern Portfolio Theory puts forth the hypothesis that investors can create portfolios which provide them maximum or optimum returns for a given level of risk. It also extolls the virtues of diversification, i.e. spreading a portfolio across asset classes as well as instruments.

Strategic Asset Allocation uses Modern Portfolio Theory as a base by making use of the efficiency of markets. It does so by determining an asset allocation, based on risk tolerance, and then sticking to it, instead of trying to assess the direction of markets. This discipline is the cornerstone of the Strategic Asset Allocation approach.

Strategic Asset Allocation Process

Assessment of Risk

The Strategic Asset Allocation process begins with the assessment of the risk tolerance level of an investor. This is done in a detailed manner with the help of questionnaires as well as via discussions between the investor and the entity constructing the portfolio.

Investment Horizon

Another key input is the investment horizon, i.e. the duration for which an investor intends to keep the money invested in the portfolio.

These two inputs are key in determining the eventual portfolio and are used in tandem. For an investor who has a high level of risk tolerance, a higher exposure to equities may not necessarily be the optimal choice unless the time-frame of investment is also known. Thus, for a high-risk investor with a short-term time horizon, a more moderate equity exposure would be suggested compared to another investor who has a similar tolerance for risk but a relatively longer time-frame to remain invested.

Broad-Based Asset Allocation

After assessing an investor’s risk profile and discussing the investment horizon, an allocation to broad-based asset classes like equities, fixed income, and cash is made keeping in mind the expected return of these asset classes given their levels of risk.

Further Allocation in Each Broad Based Asset Classes

This step is followed by further breaking down these broad asset classes into categories divided into market capitalization groups, by geographical divisions, or by analytical groups or any other method. Similar to the broad-based asset classes, percentage allocation to these categories follow the next step.

Monitoring and Rebalancing

After the Strategic Asset Allocation is determined, it is monitored and rebalanced on a particular frequency like bi-annually or annually.

Let’s see how this works by an example.

Rebalancing in the Strategic Asset Allocation Process

Though Strategic Asset Allocation is akin to a buy and holds strategy, this is not to say that it is not monitored. Portfolio rebalancing ensures that after a pre-determined period, the entity managing the portfolio makes changes to the allocation in order to ensure that the allocation to the broad asset classes, namely, equities, fixed income, and cash, is brought back to the level which was determined initially. This is required because the returns from these asset classes change the asset allocation, given their performance over the course of the period.

Example of Rebalancing

Initial Investment

For instance, let’s consider an investor with $100,000 to invest. According to his risk tolerance level and investment horizon assessment, let’s assume that the Strategic Asset Allocation comes out to be 60% to equities, 30% to fixed income, and 10% to cash. This means that $60,000 of the aforementioned investment pool will be invested in stocks, $30,000 will be invested in bonds, and $10,000 will be invested in cash and cash equivalents. The rebalancing frequency has been fixed as annually.

Rebalancing

After one year, let’s assume that the equities portion of the portfolio has returned 20%, fixed income has returned 9.5% and cash has returned 2.5%. This performance has increased the overall value of the portfolio to $115,100 with the value of equities, fixed income, and cash segments standing at $72,000, $32,850, and $10,250 respectively. But due to this change in value, the allocation of these asset classes now stands at 62.6%, 28.5%, and 8.9% respectively, which is a deviation from the 60:30:10 mix that was determined initially.

New Status

According to the initial asset allocation mix, the value of the equities segment should be $69,060, that of fixed income should be $34,530, and that of cash should be $11,510 given the new value of the overall portfolio. This means that $2,940 from the equities segment needs to be sold off and the proceeds need to be used to buy $1,680 worth of bonds with the remaining $1,260 being invested in cash and cash equivalents.

Conclusion

In this manner, rebalancing compels the investor to book profits from the segments which are doing well and redeploy to other asset classes.

Given the effectiveness of the diversification of portfolio, and the discipline that comes with investing in the Strategic Asset Allocation strategy, an investor can reap the benefits of relatively low correlation between broad asset classes as well as securities comprising these asset classes, as over long period s of time, no particular asset class is expected to outperform the others consistently.

References:

Last updated on : March 19th, 2018
What’s your view on this? Share it in comments below.

Leave a Reply

Weighted Average Cost of Capital (WACC)
  • Advantages and Disadvantages of Equity Valuation
    Advantages and Disadvantages of Equity Valuation
  • Constant Growth Rate Discounted Cash Flow Model/Gordon Growth Model
    Constant Growth Rate Discounted Cash Flow Model/Gordon …
  • Arbitrage Pricing Theory
    Arbitrage Pricing Theory
  • Types of Weights for WACC
    Market vs. Book Value WACC
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Recent Posts

    Find us on Facebook


    Related pages


    issuing debenturesdebt covenants examplessimilarities between international trade and domestic tradewhat is vertical mergerpay back period calculationwhat is bond and debentureadvantages of payback methodbep analysisdefine discounted cash flowhow to classify fixed assetswhat is a profitability indexwhat is the difference between profit maximization and wealth maximizationadvantages and disadvantages of mergers and takeoverswhat are cost drivers in accountingselling assets advantages and disadvantageswhat is the wacccapitalizing expendituresprofitability index method of capital budgetingnopatmeaning of equity shares in hindigordon growth formulaaccounts receivable to working capital ratiodefinition of owners equitywhat does accounts receivable turnover meanhiring and leasing definitionsight and usance letter of creditleverage pronouncewhat is a non convertible debenturemulti stage dividend discount modelacid test liquidity ratiodividend ratio formulaflexible budget advantages and disadvantagesloan turnover ratiohow to calculate receivablescomputing payback periodwaccsgrowth rate in dividends formulareceivables collection periodexamples of capital leasespros and cons of activity based costingactivity based budgeting examplegaap straight line depreciationbonds and debentures differencenpv benefitsdays to collect accounts receivablecapitalized interest expenseoperating leverage formula accountingdifference between current ratio and quick ratiodebt financing pros and consmeaning of paybackrationed meaningaverage settlement period for trade receivablesfinance lease v operating leasevaluation waccmodigliani and miller 1961revaluation bookswacc calculationswealth maximization and profit maximizationwhat is an installment sales contractissued subscribed and paid up capitalwhat is debentures in accountingwhat is meant by weighted average cost of capital waccmeaning of debit and credit in accountingratio analysis interpretationhypothecated definitionhow to do inventory turnoveris depreciation a period costhire purchase liabilitiesdefine installmentlamens terms definitionddm stockdscr ratio analysismanagerial accounting variance analysis2 stage dividend discount modeladvantages and disadvantages of investment appraisal