Markets can be volatile and unpredictable. There can be significant ups and downs in the market. However, a well-diversified portfolio across uncorrelated asset classes can protect investors from volatility as well as give stable returns in all market conditions. This strategy is called Asset Allocation. With asset allocation, a diversified portfolio is created across asset classes like equity, gold, debt, and liquid instruments.
Depending on the market scenario, allocation to each asset class is varied optimizing the best possible return over the long run. For example during a bull run, equity is given a higher allocation and during a risky/volatile phase gold/debt instruments are given a higher weightage to protect the portfolio against volatility. Asset allocation is key to reduce risks for investors through diversification of their portfolio especially during market crashes. Asset allocation strategies were able to provide a cushion to the portfolio minimizing the drawdown. Moreover, during the bull run, these strategies were able to switch allocation and maximize portfolio returns as well. Asset allocation helps in achieving an individual's financial goals. It can be tailored specifically for individuals who have different levels of risk appetite. For example, an individual with a low-risk appetite will invest more in gold/debts like any other fixed income. On the other hand, an investor with a higher risk appetite invests in equities. Taking these factors into consideration a portfolio can be curated that best fits the financial goals of the investor.
Asset allocation involves dividing one's investment portfolio among different asset classes, but the process of determining the mix or the ratio of the asset categories is a very personal one which is also dependant on one's goals, risk appetite, and the time horizon to stay invested.
One needs to define his or her financial goals for eg., buying a house, higher education for children, or retirement planning.
Then one needs to also assess what is the amount of risk he is willing to take or is capable of tolerating.
And then the time frame that one would like to stay invested.
A simple illustration would be if one has retired, which means there is no regular income flow that is coming, it is advisable to put those investments in fixed-income funds, bonds, and cash as it is more stable. This would aim at preserving the corpus of money which is earned over the years. However, if you have 25 years of investing and a long-term goal of your child’s higher education, you may want to invest a larger share in equity /equity funds like 60-70% in Equity, 20% in Debt, and 10% in Cash.
While asset allocation, once done, reduces the need in a portfolio from daily monitoring, it does not mean that one does a one-time asset allocation and then just forgets about it. It is always advisable to review your portfolio either with your financial advisor or personally at regular intervals and maybe adjust your asset allocation from time to time to ensure you meet your financial goals.
Providing a disciplined approach to diversification. An asset allocation strategy is another name for diversification, an important strategy for reducing portfolio risk. Since different investments are affected differently by economic events and market factors, owning different types of investments helps reduce the chance that your portfolio will be adversely affected by a particular risk type.
Encouraging long-term investing. An asset allocation strategy is designed to control your portfolio's long-term makeup. It should not change based on economic conditions or market fluctuations. Over time, your asset allocation might change based on changes in your financial situation, your age, and your progress toward your financial goals.
Eliminating the need to timing your investment decisions. Market timing is difficult to implement. It is even harder to be right consistently. An asset allocation strategy based on your goals and risk tolerance is a much better approach for most investors.
Reducing the risk in your portfolio. Investments with higher returns typically have a higher risk and more volatility in year-to-year returns. Asset allocation combines more aggressive investments with less aggressive ones. This combination can help reduce your portfolio's overall risk.
Adjusting your portfolio's risk over time. Your portfolio's risk can be adjusted by changing allocations for the different investments you hold. By anticipating changes in your personal situation, you can make those changes gradually. Focusing on the big picture. Staying focused on your asset allocation strategy will help prevent you from investing in assets that won't help accomplish your goals. Rather than investing haphazardly, it gives you a framework for making investment decisions. A key factor in the success of an asset allocation strategy is a commitment to the periodic review and rebalancing of your portfolio. You should set ranges for each investment category, perhaps plus or minus 5 percent away from the target allocation. The portfolio should be rebalanced when one or more categories fall outside of those ranges.
Strategic Asset Allocation
This method establishes and adheres to a base policy mix—a proportional combination of assets based on expected rates of return for each asset class. You also need to take your risk tolerance and investment time-frame into account. You can set your targets and then rebalance your portfolio in a systematic manner.
A strategic asset allocation strategy may be akin to a buy-and-hold strategy and also heavily suggests diversification to cut back on risk and improve returns.
For example, if stocks have historically returned 10% per year and bonds have returned 5% per year, a mix of 50% stocks and 50% bonds would be expected to return 7.5% per year.
Constant-Weighting Asset Allocation
Strategic asset allocation generally implies a buy-and-hold strategy, even as the shift in values of assets causes a drift from the initially established policy mix. For this reason, you may prefer to adopt a constant-weighting approach to asset allocation. With this approach, you continually rebalance your portfolio. For example, if one asset declines in value, you would purchase more of that asset. And if that asset value increases, you would sell it. There are no hard-and-fast rules for timing portfolio rebalancing under strategic or constant-weighting asset allocation. But a common rule of thumb is that the portfolio should be rebalanced to its original mix when any given asset class moves more than 5% from its original value.
Tactical Asset Allocation
Over the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore, you may find it necessary to occasionally engage in short-term, tactical deviations from the mix to capitalize on unusual or exceptional investment opportunities. This flexibility adds a market-timing component to the portfolio, allowing you to participate in economic conditions more favorable for one asset class than for others. Tactical asset allocation can be described as a moderately active strategy since the overall strategic asset mix is returned to when desired short-term profits are achieved. This strategy demands some discipline, as you must first be able to recognize when short-term opportunities have run their course and then rebalance the portfolio to the long-term asset position.
Dynamic Asset Allocation
Another active asset allocation strategy is dynamic asset allocation. With this strategy, you constantly adjust the mix of assets as markets rise and fall, and as the economy strengthens and weakens. With this strategy, you sell assets that decline and purchase assets that increase. This makes dynamic asset allocation the polar opposite of a constant-weighting strategy. For example, if the stock market shows weakness, you sell stocks in anticipation of further decreases and if the market is strong, you purchase stocks in anticipation of continued market gains.
Insured Asset Allocation
With an insured asset allocation strategy, you establish a base portfolio value under which the portfolio should not be allowed to drop. As long as the portfolio achieves a return above its base, you exercise active management, relying on analytical research, forecasts, judgment, and experience to decide which securities to buy, hold, and sell to increase the portfolio value as much as possible. If the portfolio should ever drop to the base value, you invest in risk-free assets, such as Treasuries (especially T-bills) so the base value becomes fixed. At this time, you would consult with your advisor to reallocate assets, perhaps even changing your investment strategy entirely. Insured asset allocation may be suitable for risk-averse investors who desire a certain level of active portfolio management but appreciate the security of establishing a guaranteed floor below which the portfolio is not allowed to decline. For example, an investor who wishes to establish a minimum standard of living during retirement may find an insured asset allocation strategy ideally suited to his or her management goals.
MPRO Asset Allocation
With MRPO asset allocation, we consider both your economic expectations and your risk in establishing an asset mix. While all of the strategies mentioned above account for expectations of future market returns, not all of them account for the investor’s risk tolerance. That's where integrated asset allocation comes into play. This strategy includes aspects of all the previous ones, accounting not only for expectations but also actual changes in capital markets and your risk tolerance. MPRO asset allocation is a broader asset allocation strategy. But it cannot include both dynamic and constant-weighting allocation since an investor would not wish to implement two strategies that compete with one another.