Using strategic asset allocation to build your portfolio

If there is one investment topic that investors should make sure they study and understand, it is asset allocation.  The reason is that apart from the general movement of the stock market, which will take many assets up or down depending on market direction, asset allocation is a primary driver for portfolio returns.

That is in direct competition with what most investors believe to the most important thing in their portfolio.  Think about your own experience trying to grow your own investment portfolio.  Where was most of your time spent?

If you are like 90% of retail investors out there, then the bulk of your time was spent searching for that one stock, one mutual fund, one ETF that was going to give you the best performance possible to grow your portfolio as quickly as possible.  That can be like finding a needle in a haystack.

Instead, a more feasible approach is to spend the time researching what your asset allocation should be and then building off of that with assets that are of high quality and provide you with solid diversification.

Let’s look at what asset allocation is and then review a specific type of asset allocation – strategic asset allocations.

What Is Asset Allocation?

Asset allocations is the percentage of each type of investment asset in an investment portfolio.  In its most simple form, an asset allocation is usually divided into equities (i.e. stocks), fixed income (i.e. treasuries and bonds), and cash.

A portfolio’s asset allocations is the percentage the investor holds in each one of these asset types.  For example, an investor could use an asset allocation of 60% equities, 35% fixed income, and 5% cash.  This is a common asset allocation that many investors choose to implement in their own portfolios.

Asset Allocation is a Balance Between Risk and Reward

Aside from determining what percentage of each asset type to hold in a portfolio. Asset allocations also strives to create a balance between risk and reward.  In other words, the investor sets up a portfolio with an asset allocations that provides an acceptable level of risk. (i.e. the ratio between risker equities to safer bonds) for a desired level or return.  The riskier you make your portfolio by holding more equities, the better the return over time can be, but at a higher risk level.

With that general understanding of what asset allocations is and its purpose in balancing risk and reward. Let’s look at a specific type of asset allocation – strategic asset allocation.

What is Strategic Asset Allocation?

Strategic asset allocation is a style of asset allocations that sets specific targets for the various asset classes available to investors. And then rebalances the portfolio when the asset allocation gets out of line.

For example, using our example above, our investor set up a portfolio one year ago with a strategic asset allocations target of 60% equities, 35% fixed income, and 5% cash.  Over the past year stocks have done very well and equities now make up 80% of the portfolio, while fixed income has dropped to 17% and cash to 3%.  

In a portfolio using strategic asset allocations, the investor would take the necessary steps to bring the portfolio back to the 60/35/5 strategic asset allocation.  This is often done on an annual basis.

How that is done can vary.  For example, the investor could add money to the account and buy enough fixed income to fix the allocation. Alternatively, the investor could sell enough of the equities to buy fixed income to balance the portfolio.  Either way, as long as the investor takes the required steps to bring the portfolio back in line with the target allocation. They will make sure they continue to maintain their risk/reward balance.

Summary

If you want to invest more like a professional investor such as large pension or endowment funds. Then the bulk of your energy should be spent on setting and maintain an asset allocation that meets your risk/reward requirements.  This has been shown to improve portfolio performance. Which leads to more money over longer periods of time.

One way to do that is to set a strategic asset allocations that provides you with enough equities. To generate the returns you need with a balancing fixed income component that will protect you. During those periods of big market draw downs that can be hard to stomach if you are too aggressive.  Just make sure that you periodically rebalance that strategic asset allocations. So that it stays in line with your target allocations.

 

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