Ruairi O'Donnellan

What is Asset Allocation?

Asset allocation is the process of deciding how an investment portfolio should be distributed across different asset classes.

Asset allocation has moved far beyond the traditional view of diversification. Sophisticated IT systems can process huge amounts of historical performance data which enables investors to construct optimal portfolios.

To build a market efficient portfolio or one that has the potential to generate an above-market return, the portfolio manager must be able to understand the risks, expected returns, correlations, and other characteristics of different classes of assets.

The approach to achieving such a return will vary according to the size and nature of different investors and their time horizon.

Investors today are more sophisticated than ever before and have high expectations from fund managers.

The impact of market crashes, declining interest rates, and the advent of alternative investments has had a significant effect on the way asset managers invest funds across different assets classes.

The basis of asset allocation is the principle of diversification and modern portfolio theory (MPT).

This principle suggests that portfolio risk can be reduced by adding assets in greater numbers to a portfolio. Studies have shown that the asset allocation decision plays an important part in portfolio performance.

The asset allocation decision depends primarily on the investor's objectives, risk tolerance, and time horizon.

In the case where investors are pooling their money into a fund, asset allocation will also depend on the fund manager's estimate of the risks and returns on various assets. 

Related article: What Does a Wealth Manager Do? 
What is asset allocation?

The Role of Asset Allocation

The asset allocation process is important in determining the performance of most investment portfolios.

Each asset class has different levels of risk and return. For example, while stocks are typically more volatile than bonds, traditionally they have offered a higher long-term return.

Related article: How to Become an Asset Manager

In general, asset classes with greater volatility pay higher average returns. 

What is Portfolio Diversification? 

Diversification enables investors to mitigate risk by reducing their dependence on the performance of one single investment.

In the asset allocation process, it is important to diversify both across asset classes and within each asset class.

The diversification effect reduces the volatility of a portfolio below a simple weighted average of the volatilities of the constituent assets. 
What is portfolio diversification?

What are Asset Allocation Strategies? 

Diversification enables investors to mitigate risk by reducing their dependence on the performance of one single investment.

By diversifying a portfolio, its volatility can be reduced below a simple weighted average of the volatilities of the constituent assets.

Investors may diversify their investment across a range of assets using one of three approaches: 

Strategic Asset Allocation  

Strategic asset allocation refers to the long-term allocation of an investment portfolio to stocks, bonds, and other assets based on an investor's goals and tolerance for risk.

A portfolio's strategic asset allocation incorporates a base policy mix that should remain unchanged even when the market moves up or down. 

Dynamic Asset Allocation 

One of the greatest problems with strategic asset allocation is that the investment portfolio must be constantly rebalanced to bring it back in line with its original composition.

This can involve selling assets that are outperforming and purchasing assets that are underperforming.

This can be counterintuitive especially if it is done to satisfy an asset allocation that was derived when conditions were different in the stock market.

Dynamic asset allocation recognizes that, as better information comes available, investors’ expected returns and volatility estimates can change accordingly.

A dynamic asset allocation allows the investor to “adapt” to the changing underlying market conditions and change the portfolio composition accordingly. 

Tactical Asset Allocation 

Tactical asset allocation is a dynamic strategy that involves making short-term adjustments to a portfolio's strategic asset allocation to take advantage of particular investment opportunities.

For example, an investor may have strategically allocated 20% of the portfolio to emerging market equities, but this weighting might be varied up or down by 5% in response to current economic or market conditions.

The investor then reverts to the overall strategic asset mix once the short-term objectives are achieved. 
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