Understanding Various Asset Allocation Strategies
Asset allocation is one of the most important investment decisions that determines the success of your investment portfolio. Based on the principle that different assets will give different returns in different market conditions, it involves dividing your investments into different asset classes based on your risk profile. So what are the different asset allocation strategies and how do you arrive at a strategy that is right for you?
Let us start by taking a look at some asset allocation strategies.
Asset Allocation Strategies
Strategic asset allocation involves determining a “base policy mix” and then sticking to the same. This refers to assigning a proportion to each asset class, based on its expected returns. For example, if equities have historically given 18% returns, bonds have given 8% and real estate has given 10% returns per annum, then a mix of 50% equities, 40% bonds and 10% real estate would generate an expected target return of 13.2% per annum. It is essentially a buy and hold strategy.
Constant-weighing asset allocation. Sometimes strategic asset allocation may seem unsuitable as changes in market conditions may change the values of assets, leading to a change in the asset mix from the initially established proportion. Adopting a constant-weighing asset allocation allows you to continuously change or rebalance your portfolio to maintain the decided proportion or asset mix.
The most common reasons of rebalancing your portfolio can be market performance or change in your life stage like starting a family or nearing retirement, when financial priorities may change. There is no limit to portfolio rebalancing under the constant-weighing asset allocation and it largely depends on market conditions and an investor’s strategy.
Tactical asset allocation is a moderately active strategy usually implemented to benefit from short-term market and economic events. Following strategic asset allocation may not leave room for flexibility to take advantage or benefit from short-term investment opportunities as the proportion remains fixed. Tactical asset allocation, therefore, gives that corridor to add the component of market timing and allows you to reap profits when the market develops favours for one asset class over others. However, do note that this is a short-term strategy and the earlier pre-determined asset mix is restored when the short-term profits are achieved. Since this requires deep knowledge of the market to accurately identify and leverage short-term opportunities, it often used by professionals like fund managers.
Dynamic Asset Allocation is again an active asset allocation strategy in which you can continuously change and adjust the asset mix depending on the market and economic conditions. It moves opposite to constant-weighting asset allocation. For example, in the dynamic strategy, you would sell when the market begins to decline to stop your losses and buy when it starts to rally in anticipation of further gains.
Lastly, Insured asset allocation, as the name suggests, works on setting a minimum threshold value for your investment portfolio. Once you determine the base value or threshold, the value of your investment portfolio must not be allowed to fall below this pre-determined level. As long as the portfolio continues to be above the base level, you can exercise active management and leverage opportunities to get the highest possible returns.
You can see now that determining the right asset allocation strategy is an ever evolving process and implementing it requires considerable time and effort to make it a success. Keeping in mind your time horizon and risk tolerance, you can close in on the right asset mix that will give you the maximum potential returns with your acceptable level of risk.
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