Asset Allocation: A Strategy For Investment Success

In today's complex financial markets, you can select from an impressive array of investment vehicles. Each investment also carries some risks, making it important to choose wisely if you are selecting just one. The good news is that there's no rule that says you must stick with only a single type of investment. In fact, you can potentially lower your investment risk and help increase your chances of meeting your investment goals by practicing "asset allocation." What Is Asset Allocation? Asset allocation refers to the way in which you weight investments in your portfolio in order to try to meet a specific objective. For instance, if your goal is to pursue growth (and you're willing to take on market risk in order to do so), you may decide to place 20% of your assets in bonds and 80% in stocks. The asset classes you choose, and how you weight your investment in each, will probably hinge on your investment time frame and how that matches with the risks and rewards of each asset class. Focus On The Three Primary Asset Classes: Stocks, Bonds, And Money Markets Here's a closer look at the risk and reward levels of the major asset classes: Stocks Well known for fluctuating frequently in value, stocks carry a high level of market risk (the risk that your investments' value will decrease after you purchase them) over the short term. However, stocks have historically earned higher returns than other asset classes over the long term, although past performance is no predictor of future results. Stocks have also outpaced inflation -- the rising prices of goods and services -- at the highest rate through the years. Bonds In general, these securities have less severe short-term price fluctuations than stocks, and therefore offer lower market risk. On the other hand, their overall inflation risk tends to be higher than that of stocks, as their long-term return potential is also lower. Money Market Instruments

Among the most stable of all asset classes in terms of returns, money market instruments carry relatively low market risk. At the same time, these securities lack the potential to outpace inflation by as wide a margin through the years as stocks. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

6 Asset Allocation Strategies That Work Establishing an appropriate asset mix is a dynamic process and it plays a key role in determining yourportfolio's overall risk and return. As such, your portfolio's asset mix should reflect your goals at any point in time. There are a few different strategies of establishing asset allocations, and here we outline some of them and examine their basic management approaches. 1 Strategic Asset Allocation Strategic asset allocation is a method that establishes and adheres to what is a "base policy mix." This is a proportional combination of assets based on expected rates of return for each asset class. 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. 2 Constant-Weighting Asset Allocation Strategic asset allocation generally implies a buy-and-hold strategy, even as the shift in the values of assets cause a drift from the initially established policy mix. For this reason, you may choose to adopt a constant-weighting approach to asset allocation. With this approach, you continually rebalance your portfolio. For example, if one asset were declining in value, you would purchase more of that asset, and if that asset value should increase, you would sell it. There are no hard-and-fast rules for the timing of portfolio rebalancing under strategic or constantweighting asset allocation. However, 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. 3 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 in order to capitalize on unusual or exceptional investment opportunities. This flexibility adds a component ofmarket timing to the portfolio, allowing you to participate in economic conditions that are 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.

4 Dynamic Asset Allocation Another active asset allocation strategy is dynamic asset allocation, with which you constantly adjust the mix of assets as markets rise and fall and the economy strengthens and weakens. With this strategy you sell assets that are declining and purchase assets that are increasing, making dynamic asset allocation the polar opposite of a constant-weighting strategy. For example, if the stock market is showing weakness, you sell stocks in anticipation of further decreases, and if the market is strong, you purchase stocks in anticipation of continued market gains. 5 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 to try to increase the portfolio value as much as possible. If, however, the portfolio should ever drop to the base value, you invest in risk-free assets so that the base value becomes fixed. At such time, you would consult with your advisor on re-allocating assets, perhaps even changing your investment strategy entirely. You can implement an insured asset allocation strategy with a formula approach or a portfolio insurance approach. The formula approach is a graduated strategy: as the portfolio value decreases, you purchase more and more risk-free assets so that when the portfolio reaches its base level, you are entirely invested in risk-free assets. With the portfolio insurance approach you would use put options and/or futures contracts to preserve the base capital. Both approaches are considered active management strategies, but when the base amount is reached, you are adopting a passive approach. 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 might find an insured asset allocation strategy ideally suited to his or her management goals. 6 Integrated Asset Allocation With integrated asset allocation you consider both your economic expectations and your risk in establishing an asset mix. While all of the above-mentioned strategies take into account expectations for future market returns, not all of the strategies account for investment risk tolerance. Integrated asset allocation, on the other hand, includes aspects of all strategies, accounting not only for expectations but also actual changes in capital markets and your risk tolerance. Integrated asset allocation is a broader asset allocation strategy, albeit allowing only either dynamic or constant-weighting allocation.

Obviously, an investor would not wish to implement two strategies that are competing with one another. Conclusion Asset allocation can be an active process to varying degrees or strictly passive in nature. Whether an investor chooses a precise asset allocation strategy or a combination of different strategies depends on that investor's goals, age, market expectations and risk tolerance. Keep in mind, however, that this article gives only general guidelines on how investors may use asset allocation as a part of their core strategies. Be aware that allocation approaches that involve anticipating and reacting to market movements require a great deal of expertise and talent in using particular tools for timing these movements. Some would say that accurately timing the market is next to impossible, so make sure your strategy isn't too vulnerable to unforeseeable errors.

Asset Allocation

The term asset allocation means different things to different people in different context. Here are some versions of asset allocation: 1. Strategic asset allocation 2. Tactical asset allocation 3. Drifting asset allocation 4. Balanced asset allocation 5. Dynamic (insured) asset allocation. While strategic asset allocation is concerned with establishing the long-term asset mix of a portfolio, the other types of asset allocation refer to what the portfolio manager does in response to evolving market conditions.

1. Strategic Asset Allocation.

The strategic asset allocation refers to the long-term normal asset mix sought by the investor (or portfolio manager) to achieve an ideal blend of risk and return. It may be established with the help of either an informal or a formal approach.

Informal approach. Essentially, it involves three broad steps: 1. Subjective assess the risk tolerance as low, medium, or high. 2. Define the investment horizon as short, intermediate, or long. 3. Establish the optimal strategic asset allocation using some rule of thumb.

Formal approach. This involves the following steps: 1. Develop quantitative forecasts of expected returns, standard deviations, and correlations of the two asset categories, viz. stocks and bonds. 2. Define the efficient frontier which contains all the efficient portfolio options available to the investor. 3. Specify the utility indifference curves reflecting the risk disposition of the investor. 4. Choose the optimal portfolio (asset allocation). The optimal portfolio is found at the point of tangency between the efficient frontier and a utility indifference curve.

2. Tactical Asset Allocation. Tactical asset allocation involves a conscious departure from the strategic or normal asset mix based on rigorous and objective measurement of value. The objective of tactical asset allocation is to enhance the performance of the portfolio through an opportunistic shift in the asset mix in response to changing patterns of reward in the capital market. The distinctive features of tactical asset allocation are as

follows: It is guided by objective measures of prospective values like earnings yield and yield to maturity. Hence it is essentially a value-oriented approach. It is inherently contrarian in nature as it involves buying after a market decline and selling after a market rise. Note that tactical asset allocation entails market timing. The only difference between the traditional market timing and tactical asset allocation (a modern version for market timing) is that the latter is supposed to be analytically disciplined and based on objective measures of value.

3. Drifting Asset Allocation. This policy advocates that the initial portfolio be left undisturbed. It is essentially a buy and hold policy. Irrespective of what happens to relative values, no rebalancing is done. For example, looking at the payoff for a buy and hold policy if the initial stock:bond mix is 50:50: The value of portfolio is linearly related to that of the stock market. While the portfolio value cannot fall below the value of the initial investment in bonds, its upside potential is unlimited. When stocks outperform bonds, the higher the initial percentage in stocks, the better the performance of the buy and hold policy. On the other hand, when stocks under-perform bonds, the higher the initial percentage in stocks, the worse the performance of the buy and hold policy.

4. Balanced Asset Allocation: A balanced asset allocation policy calls for a periodical rebalancing of the portfolio to ensure that the stock-bond mix is in line with the long-term normal mix. Put differently, this policy calls for maintaining an exposure to stocks that is a constant proportion of portfolio value. If the desired constant mix of stocks and bonds is say 50:50, this policy calls for rebalancing the portfolio when relative values of its components change, so that the target proportions are maintained (constant mix policy). Thus, this policy, unlike the buy-and-hold policy is a do something policy.

5. Dynamic (or Insured) Asset Allocation Dynamic (or insured) asset allocation involves shifting the asset mix mechanistically in response to changing market conditions. For example, the fund manger may follow a constant proportion portfolio insurance (CPPI) policy. The CPPI policy calls for selling stocks as they fall and buying stocks as they rise. This implies that this policy is the opposite of the constant mix policy which calls for buying stocks as they fall and selling stocks as they rise. Comparative Evaluation While tactical asset allocation calls for discretionary shifts, the remaining three kinds of asset allocation, viz. the drifting asset allocation, the balanced asset allocation, and the dynamic (or insured) asset allocation involve asset-mix changes in accordance with a fixed rule. It may be instructive to compare them. (Basically, the drifting asset allocation = buy and hold, the balanced asset allocation = buying stocks as they fall and selling stocks as they rise, and the dynamic (insured) asset allocation = selling stocks as they fall and buying stocks as they rise.) The payoffs associated with the drifting asset allocation policy (or buy and hold policy), the balanced asset allocation policy (or constant mix policy), and the dynamic asset allocation policy (typified by the CPPI policy) are represented by a straight line, a concave curve, and a convex curve respectively. Looking at the graphs of payoffs associated with these various allocation policies, suggests that if the stock market moves in only one direction, either up or down, the best policy is the CPPI policy and the worst policy is the balanced asset allocation policy. In between lies the drifting asset allocation policy. However, if the stock market reverses itself frequently, rather than moving in the same direction, the balanced asset allocation policy tends to be superior to other policies. To illustrate this point, let us look at the payoff from an initial investment of 100,000 when the market moves from 100 to 80 and back to 100 under the following three policies. 1. A drifting asset allocation policy under which the initial stock-bond mix is 50:50 2. A balanced asset allocation policy under which the stock-bond mix is 50:50 3. A CPPI policy which takes the form: investment in stocks = 2 (Portfolio value 75,000) The performance features of the three policies are summarized below:

1. Drifting Asset Allocation Policy (buy and hold) Gives rise to a straight line payoff Provides a definite downside protection Performs between the constant mix policy and the constant proportion portfolio insurance policy. 2. Balanced Asset Allocation Policy (buying stocks as they fall and selling stocks as they rise) Gives rise to a concave payoff drive Does not provide much downward protection and tends to do relatively poorly in up market. Tends to do very well in flat, but fluctuating, markets. 3. CPPI Policy (selling stocks as they fall and buying stocks as they rise.) Gives rise to a convex payoff curve. Provides good downside protection and performs well in up market. Tends to do very poorly in flat, but fluctuating, markets. Why Various Policies Coexist As the market advances, investors wealth increases but prospective returns diminish; likewise, as the market declines, investors wealth decreases but prospective returns improve. Investors broadly display four kinds of responses to these changes: A. Some investors are unaffected by fluctuations in wealth and their risk tolerance remains the same. They are the true long-term investors. When the market advances and prospective stock returns diminish, these investors increase their exposure to bonds. On the other hand, when the market declines and prospective returns increase, these investors increase their exposure to stocks. These investors naturally resort to tactical asset allocation (contrarian - buying after a market decline and selling after a market rise). B. Other investors are mildly affected by changes in wealth. If their wealth increases, in the wake of a market advance, their risk tolerance too increases, albeit slightly. Similarly, a market decline diminishes their risk to tolerance, though slightly. These investors naturally prefer balanced asset allocation (constant mix policy - buying stocks as they fall and selling stocks as they rise).

C. Still another class of investors displays a somewhat greater sensitivity to recent changes in wealth. As the market rises, their risk tolerance increases and they feel no need to decrease their exposure to stocks, despite diminished prospective returns. Likewise, when the market falls, their risk tolerance diminishes and they feel no need to increase their exposure to stocks. These investors are the natural candidates for the policy of drifting asset allocation (buy-and-hold). D. Finally, there is a class of investors which reacts very sharply to recent market movements. If the market rises, their risk tolerance increases sharply and they want to increase their exposure to stocks, notwithstanding the diminished prospects. If the market falls, their risk tolerance falls sharply and they want to diminish their exposure to stocks. These investors are natural candidates for a policy of dynamic (or insured) asset allocation which says Buy after a market rise and sell after a market fall. Therefore, the risk tolerance of different classes of investors varies in response to recent returns. Thus we find that there are natural candidates for tactical asset allocation, balanced asset allocation, drifting asset allocation, and dynamic (or insured) asset allocation. Just as tactical asset allocation is right for some investors, dynamic asset allocation is right for others.

Reference: Investment Analysis and Portfolio Management by Prasanna Chandra (Tata McGraw Hill)