Asset Allocation Strategies
Asset allocation is spreading your investments across multiple asset classes to help manage risks and optimize your portfolio according to your investment goals. There are several asset allocation strategies, with the two most common being strategic and tactical asset allocation.
Asset allocation strategies are not to be confused with investment strategies. Investment strategies refer to approaches for investing in assets within an asset class (for example value investing, or growth investing in the stock market). Asset allocation strategies refer to how to utilize several asset classes within your portfolio.
The choice of an asset allocation strategy, and the split percentages for different asset classes, should take into account several factors such as your risk tolerance, time horizon, and individual circumstances.
Strategic Asset Allocation
With strategic asset allocation, the percentage split for the different asset classes is fixed for the investment horizon. The portfolio is rebalanced when price gains and losses cause the percentages to change. For example, suppose that the investor starts with a portfolio of 20% bonds and 80% stocks. If bonds under perform while the stock market booms, the percentage allocations can change to 10% bonds and 90% stocks. Then, the portfolio needs to ve rebalanced by selling stocks and buying more bonds to restore the original allocation.
The rebalancing can be done either periodically, or when the allocation for any asset deviates by more than 5/% from the target allocation.
Tactical Asset Allocation
Tactical asset allocation is similar to strategic asset allocation, but the main difference is that the allocation percentages can be changed temporarily in order to take advantage of opportunities in the markets. For example, suppose that the target allocation is 20% bonds and 80% stocks. If the investor expects the stock market to decline for a period of time and the bond market to perform better, he can adjust the allocation to 40% bonds and 60% stocks temporarily and restore the original allocation when the stock market condition improves.
With tactical asset allocation, there is a timing element to the strategy. This requires skill and expertise to execute effectively.
How to choose the allocation percentages?
The right allocation percentage depends on the individual situation of the investor. Stocks are riskier than bonds and a stock market crash can take years to recover from. For an investor approaching retirement or preparing to buy a home, capital preservation might be a higher priority goal than pursuing the highest gains. Younger investors have more time to wait for stocks to bounce back after a decline, and also have more years of income and wealth building to go.