Reviewed by Thomas J. Catalano
Asset allocation is a very important part of creating and balancing your investment portfolio. After all, it is one of the main factors that leads to your overall returns—even more than choosing individual stocks. Establishing an appropriate asset mix of stocks, bonds, cash, and real estate in your portfolio is a dynamic process. As such, the asset mix should reflect your goals at any point in time.
Below, we’ve outlined several different strategies for establishing asset allocations, with a look at their basic management approaches.
Key Takeaways
- Asset allocation is very important to create and balance a portfolio.
- All strategies should use an asset mix that reflects your goals and should account for your risk tolerance and length of investment time.
- A strategic asset allocation strategy sets targets and requires some rebalancing every now and then.
- Insured asset allocation may be geared to investors who are risk-averse and who want active portfolio management.
1. 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 every now and then.
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.
But before you start investing, you should first read if you can make money in stocks.
2. 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. 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 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.
Important
The asset mix in your portfolio should reflect your goals at any point in time.
4. 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.
Note
Dynamic asset allocation relies on a portfolio manager’s judgment instead of a target mix of assets.
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, relying on analytical research, forecasts, judgment, and experience to decide which securities to buy, hold, and sell with the aim of increasing 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 their 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 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 for actual changes in capital markets and risk tolerance.
Integrated asset allocation is a broader asset allocation strategy. However, it cannot include both dynamic and constant-weighting allocation since an investor would not wish to implement two strategies that compete with one another.
What Is a Good Asset Allocation by Age?
What is considered a good asset allocation will vary for every individual, depending on their financial goals, risk tolerance, and financial profile. General financial advice states that the younger a person is, the more risk they can take to grow their wealth as they have the time to ride out any downturns in the economy. Such portfolios would lean more heavily toward stocks.
Those who are older, such as in retirement, should invest in more safe assets, like bonds, as they need to preserve capital. A common rule of thumb is 100 minus your age to determine your allocation to stocks. For example, if you are 30, then you’d allocate 70% to stocks and 30% to bonds (100 – 30 = 70). If you are 60, you’d allocate 40% to stocks and 60% to bonds (100 – 60 = 40).
What Is the Safest Place to Put Your Money in Retirement?
The safest place to put your money in retirement is low-risk investments, like high-yield savings accounts, certificates of deposit (CDs), Treasuries, and money market accounts. These investments offer capital preservation through stable assets that generate a return (albeit low returns). You should also keep cash on hand for emergencies.
How Do I Allocate My Investment Portfolio?
How you allocate your investment portfolio will depend on a variety of factors, such as age, financial profile, investment goals, and risk tolerance. Generally, your investment portfolio should have a diversified asset allocation to spread risk. This includes investing in stocks, bonds, real estate, and other investments. Within these investments, you should also diversify.
For example, in stocks, you can invest in blue-chip companies in the healthcare and manufacturing sectors as well as investing in small-cap companies in the oil and automobile sectors. Within bonds, you can choose Treasuries and corporate bonds. Remember to regularly rebalance your portfolio as market conditions and your investment profile change.
The Bottom Line
Asset allocation can be active 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 these are only general guidelines on how investors may use asset allocation as a part of their core strategies.
Be aware that allocation approaches that involve reacting to market movements require a great deal of expertise and talent in using particular tools for timing these movements. Perfectly timing the market is next to impossible, so make sure your strategy isn’t too vulnerable to unforeseeable errors.