What is Asset Allocation?

Asset Allocation

Asset allocation is the process of trying to figure out how much of your money you want to invest in an asset class. The ultimate goal is to design an asset allocation that will meet your risk comfort level and generate a return that will meet your investment objective.

Why Is Asset Allocation Important?

If you’ve ever purchased a mutual fund from a financial institution, you’ve likely gone through the asset allocation process and nodded along when you may not have been sure what the advisor was saying. Here is a short background on why asset allocation is an important thing when it comes to investment. Three guys named Gary Brison, Randolph Hood, and Gary Brinson who were bored (I assume) decided to research the effects of asset allocation. These wonderful lads found out that 93.6% of a portfolio’s variation in return was largely due to the strategic asset allocation of the portfolio.

This was huge. It basically confirmed that 93.6% of an investor’s return can be attributed to their asset allocation selected.  Great, right? Well, yes and no. Most people interpreted the lad’s research paper on asset allocation as return variation rather than risk variation among portfolios. They weren’t really looking at returns associated with asset allocation but rather risk associated with different types of portfolios. Therefore, their findings weren’t saying that asset allocation was largely the cause of a portfolio return but rather the level risk associated (fluctuations) with a portfolio is largely a result of the asset allocation selected.

Nonetheless, asset allocation is an extremely important thing when it comes to the expected return and risk of your investment. Therefore, it’s important you understand the underlining reason as to why you’re in a balanced fund, growth fund, or any other fund. Failing to understand the reason behind your decision to invest your money into 70% equities and 20% in fixed income will likely mean you will not stay with your investment strategy as you do not fully understand why your doing what you’re doing.

How to Create an Asset Allocation

Asset allocation has three components; setting a long-term strategic asset allocation, rebalancing, and if warranted you might also include a tactical asset allocation target. Let me explain how these three parts work together to create your asset allocation.

What is Strategic Asset Allocation?

Your strategic asset allocation is the long-term combination of asset classes that you believe will meet your risk and return objectives over the long term. For example, a strategic asset allocation mix might be 10% cash, 40% fixed income, and 50% equity. Since this is your strategic asset allocation, it means you want your investment portfolio to stay within this asset mix for the long term.

The determination of the asset mix is a combination of art and science. But in general, you must consider what you expect the market to do based on past performance and also consider your personal risk level. For example, you might seek a 10% return and a portfolio mix of say 70% equity and 30% fixed income has generally delivered such a return over the long term while year-over-year returns can involve a 20% decline in some years. However, if your personal risk profile cannot tolerate the 20% decline in some years, such a strategic asset allocation may not suit you. While the expected return meets your personal return objectives, they do not meet your risk comfort level and you would not be able to keep to that strategy over the long term.

Over your investment period, the strategic asset allocation will likely drift below or above the portfolio’s target, therefore, it’s important to rebalance the portfolio.

How to Rebalancing Your Investment Portfolio

Over a long period of time, your investment will move up or down above your desired strategic asset allocation. Rebalancing your portfolio is the process of selling investments within your portfolio to bring the portfolio back in line with your strategic asset allocation target. Rebalancing of the portfolio can be done mainly in two ways; celender-based rebalancing and weight-based rebalancing.

What is the Difference between Weight-Based and Calendar Portfolio Rebalancing?

A calendar-based approach to rebalancing your portfolio means you rebalance your portfolio at a set time during the year. It might be once per year, every six months, or quarterly. When the time comes, you rebalance the portfolio back to the strategic asset allocation target regardless of the market conditions or how well certain asset classes may have performed.

A weight-based portfolio rebalancing will rebalance a portfolio based on a certain percentage. For example, you might rebalance the portfolio based on a 5% increase up or down. If your equities portion of your strategic asset allocation is 2% above your target, you may not rebalance as you believe equity can still go up in value and it hasn’t reached your percentage target for rebalancing. This allows the opportunity to participate in market increases while also providing a cap to avoid you moving away from your strategic asset allocation.

How Often Should You Rebalance Your Investment Portfolio?

There isn’t an absolute rule to this question. Some research shows that too much rebalancing can impact returns while others show rebalancing can improve performance. I think the best way to approach your rebalancing is to be balanced about it. You should at least rebalance once per year and certainly,  a daily or monthly rebalancing is likely not warranted unless you’ve got a unique situation. You also have to keep in mind that rebalancing may incur some costs, which again will impact the overall return of your investments after fees are accounted for.

Whether you decide to use the weight-based, calendar, or a combination of both to rebalance your portfolio, the critical thing is to be consistent with it throughout your investment lifetime.

What is Tactical Asset Allocation?

Tactical Asset Allocation is the third part of asset allocation creation but it is optional. You are not required to have this but a tactical asset allocation allows your strategic asset allocation mix to move away from its long-term objective to take advantage of market opportunities in the short term. For example, if you believe that equities will do well this year, you might allow your equity allocation to exceed its strategic asset allocation to take advantage of the market opportunity. As such, you may shift your asset mix to 60% equity and 40% fixed income, while your normal strategic asset allocation is usually 10% cash, 40% fixed income, and 50% equity.  In apply a tactical asset allocation, it will enable you to participate in the equity gain.

It’s important this is a short-term strategy and shouldn’t replace your strategic asset allocation. To avoid this occurring, setting up a percentage limit will help avoid your portfolio going completely off course. For example, you might cap your equity gains at 10% above your strategic asset allocation to avoid moving too far away from your long-term objectives.

Your strategic asset allocation is your secret formula for success, therefore, don’t mess with the source too much. It enables you to meet your return objective while also ensuring your portfolio mix meets your risk comfort level. Rebalancing is the process of ensuring that formula is kept in place over the long term.

Think long-term when it comes to investing and remember to rebalance at least once a year to ensure your strategic asset allocation is maintained.

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