Determining the optimal asset allocation range for your investment portfolio
Many investors agonize over choosing individual stocks, without realizing that strategizing a smart approach to asset allocation is even more important. After all, predicting which individual stocks will dramatically outperform the market is difficult, but balancing your money between domestic stocks, foreign stocks, bonds, cash, real estate, and other asset classes can mitigate risk and sustain growth through changing market conditions.
An oft-cited study by economists Roger Ibbotson and Paul Kaplan asserts that more than 90 percent of a portfolio’s long-term returns are driven by its asset allocation.
Asset allocation basically boils down to portfolio diversification: creating an investment strategy that maximizes risk-adjusted returns and helps you meet your investment goals by determining how your portfolio or net worth should be divided among various asset classes.
Why asset allocation matters
Returns from the three major asset categories—stocks, bonds, and cash—generally don’t move in lockstep. Proper asset allocation can reduce risk by limiting losses and reducing the fluctuations of investment returns without sacrificing too much potential gain.
But get this wrong and your returns can significantly suffer—and so can your ability to meet your financial goals. Fail to include enough risk in your portfolio and your investments may not earn a large enough return to achieve a long-term goal such as saving for retirement. But include too much risk and funds may not be there when you need them, especially if your financial objective is near-term.
Equities offer the highest potential rewards but also the highest risk, and treasury bills backed by the government have the lowest risk but also the lowest returns. The process of choosing the right mix of assets to hold in a portfolio is a very personal one. It’s largely based on your time horizon and ability to tolerate risk.
Asset allocation should be periodically re-evaluated and rebalanced to reflect your goals at any point in time. The general rule is that an investor should gradually reduce risk exposure over the years, reaching retirement with a reasonable amount of savings squirreled away in safe investments.
6 strategies for asset allocation
Let’s take a look at several different strategies for establishing asset allocations that enable investors to achieve high returns while reducing volatility along the way.
- Strategic Asset Allocation. This traditional buy-and-hold method is one of the most common and easiest strategies for building wealth. It involves setting targets for what percentage of your money should be allocated to different investment categories based on expected rates of returns, your risk tolerance, and your investment time-frame—and then sticking with that allocation for many years.
In a nutshell, the strategy is to passively hold, add money, and rebalance your portfolio from time-to-time. Instead of changing allocations based on market conditions, investors strive to maintain the same weighting by periodically selling assets that go up and buying dips in underperforming asset classes.
By using a disciplined strategic approach, investors can avoid making emotional short-term decisions based on current market events that are likely to rob them of future returns when the market straightens out. The only major change for a strategic asset allocation approach may be skewing more conservatively over time: for instance, young investors that start out with a high stock allocation may gradually decrease the allocation of stock and increase the allocation of bonds.
- Tactical Asset Allocation. Over the long run, some investors chafe against the rigidity of the strategic asset allocation strategy. Tactical asset allocation is a more advanced, hands-on approach that involves occasionally engaging in short-term, tactical deviations in order to capitalize on exceptional investment opportunities.
This strategy is considered “moderately active” because the overall strategic asset mix is rebalanced once short-term profits are achieved. It gives investors flexibility to add a market-timing component to their portfolio and it can substantially reduce volatility.
But there is a caveat: investors must be able to realize when short-term opportunities have run their course and revert back to the long-term approach. This strategy is prone to human error and can hurt your returns if executed poorly.
- Constant-Weighting Asset Allocation. Strategic asset allocation maintains an overall buy-and-hold strategy, even when a shift in asset values causes the portfolio to diverge from the original percentage targets. A constant-weighting approach continually rebalances the portfolio, never letting any given asset class move more than 5 percent from its original value. Basically, if an asset declines in value, you buy more. If it increases, you sell it.
- Dynamic Asset Allocation. Instead of relying on a target mix of assets, this strategy relies on a portfolio manager’s judgment to constantly adjust the mix of assets along with changes in the market and economy. This strategy is the opposite of constant-weighting, encouraging investors to unload assets that decline and purchase ones that increase.
- Insured Asset Allocation. This strategy is often preferred by risk-averse investors who also want to dabble in active portfolio management. Insured asset allocation protects their investment by establishing a base value that the portfolio can’t fall below.
If returns are above the base, investors can engage in active management—tapping into analytical research, forecasts, and judgment to buy, hold, and sell securities so the portfolio value continues to increase. If returns fall below the base, investors target risk-free assets such as treasury bills until the base value becomes fixed. At that point, an advisor is consulted to reallocate assets and potentially readjust the investment strategy.
- Integrated Asset Allocation. Most investment strategies are based on expectations of future market returns, but not all of them consider an investor’s appetite for risk. With integrated asset allocation, asset mixes are based on an investor’s economic expectations and tolerance for risk. This strategy includes elements of the other approaches but it’s broader, also accounting for changes in capital markets and the investor’s risk tolerance. It can follow the principles of constant-weighting or dynamic asset allocation.
Choosing the right asset allocation strategy
Every investment is subject to risk and market ups and downs. When done properly, asset allocation is an essential investing tool that can protect an investor’s portfolio from the movement of a single asset class. But settling on an approach that involves reacting to market fluctuations requires a high level of expertise. A qualified investment advisory firm can help investors select and manage an asset allocation strategy that helps them achieve their financial goals.
Lindberg & Ripple is an independent investment and insurance advisory firm providing sophisticated Wealth Management, experienced Investment Consulting, and innovative Insurance Solutions for wealthy families, successful executives, and business executives. Contact us to learn how we can help your family or business achieve your financial objectives, while minimizing hassle, expense, and taxes.