Definition
Asset allocation is the rigorous implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals and investment time frame. The focus is on the characteristics of the overall portfolio. Such a strategy contrasts with an approach that focuses on individual assets.
Asset Allocation
To lower risk, minimize volatility and maximize returns, investors often use a financial technique called asset allocation. This strategy is used primarily to spread investment dollars over several assets/asset categories.
Asset allocation technique can be best defined as a diversification strategy which ensures that all assets in your portfolio don’t respond to the same forces of the market in the same manner and at the same time. So if one market performs poorly and the other performs well, you will be able to offset losses with gains, thus minimizing the overall impact or effect on your asset portfolio.
How to Select Asset Categories?
This depends on several factors. However, the most important ones are:
- Risk tolerance
- Portfolio size
- Investment goals
- Time frame (how long do you plan on keeping your money invested)
A simple asset allocation portfolio may include 2 to 3 investment categories. The 3 main asset categories may include: equities, cash and fixed-income. As they all behave differently, it is easier to balance out risks and returns. On the other hand, a more complex asset portfolio may include 6 to 7 asset categories.
When creating your asset allocation portfolio, keep ‘balance diversification’ in consideration. This helps lower risk and improves portfolio returns.
Asset Allocation Types
Asset allocation can be divided into three types: tactical, constant weighting and dynamic.
- Tactical
Tactical allocations have a short term deviation. For example, increasing the exposure to goods when they’re in demand and then slowly reverting back to the strategic level once short term gains are realized - Constant Weighting
This type of asset allocation primarily responds to the rise and fall in the values of the portfolio. For instance, if equities rise in value to 60% from the strategic 50% level, then for weighting shares will be sold while other assets will be bought. - Dynamic
As the name suggests, dynamic allocation refers to regular adjustments of the asset mix. This strategy takes advantage of the ever-changing market conditions.
To create a high yielding portfolio, it’s best to work with an experienced portfolio investment manager who can guide you and help implement the right strategies at the right time. By diversifying your portfolio smartly across categories like cash, bonds, real estate, commodities, shares and private equity, you can easily maximize your potential for compound returns.
Further Reading
- How regimes affect asset allocation – www.tandfonline.com [PDF]
- Flexible dynamic conditional correlation multivariate garch models for asset allocation – www.tandfonline.com [PDF]
- Tracking error and tactical asset allocation – www.tandfonline.com [PDF]
- A risk management approach to optimal asset allocation – ideas.repec.org [PDF]
- Gender‐based risk aversion and retirement asset allocation – onlinelibrary.wiley.com [PDF]
- An asset allocation puzzle – www.nber.org [PDF]
- Asset allocation and asset location: Household evidence from the Survey of Consumer Finances – www.sciencedirect.com [PDF]
- The impact of skewness and fat tails on the asset allocation decision – www.tandfonline.com [PDF]
- Asset allocation in a downside-risk framework – www.tandfonline.com [PDF]
