Different Types of Asset Allocation Strategies

Each asset we include in our investment portfolio carries its own set of risks and rewards. When we limit ourselves to high-risk, high-return assets or opt exclusively for low-risk, low-return ones, we may miss out on optimizing our portfolio’s potential. Investors should seek out strategies that help strike a balance between risk and reward.

In this article, let’s explore various strategies for asset allocation.

Balancing Act: The Two Key Goals of Asset Allocation

The two primary goals when it comes to asset allocation:

• To maintain the same level of returns as before asset allocation but with lower risk
• To achieve better returns while keeping the risk at the same level

In theory, assets with higher risk potential tend to offer higher returns, while those with lower risk potential typically yield lower returns. By diversifying their portfolio among various assets with varying risk-to-return ratios, investors can tailor their investments to align with their financial goals.

Types of Asset Allocation Strategies

The three major types of asset allocation strategies are

1. Strategic Asset Allocation

Strategic asset allocation (SAA) strategies are characterised by their long-term perspective, taking into account factors such as the investor’s income, age, and risk tolerance. These strategies are typically passive in nature and can be described as ‘buy-and-hold’ approaches.

In this approach, investors assess the anticipated risks and returns associated with different assets. Using these risk-reward considerations, they make decisions about how to distribute their investments based on their financial circumstances. The allocation among various asset classes is adjusted periodically.

SAA strategies can be divided into three sub-categories:

• Age-based Asset Allocation

Asset allocation strategy based on age refers to the practice of adjusting one’s investment portfolio composition in line with their age. 

Generally, younger individuals may opt for a more aggressive allocation, with a higher proportion in stocks for potential growth, while older individuals may favour a more conservative allocation, with a greater emphasis on bonds or cash for capital preservation.

• Risk Profile-Based Asset Allocation

Risk profile-based asset allocation strategies take into account the investor’s risk profile in order to decide how to allocate assets.

Investors can be categorised into five groups:

• Conservative
• Moderately Conservative
• Balanced
• Moderately Aggressive
• Aggressive

Conservative investors possess the least risk tolerance and prefer portfolios with low volatility. In contrast, aggressive investors opt for high-volatility portfolios with the potential for high returns.

Consequently, conservative investors tend to hold more assets that offer low risk and low returns, while aggressive investors tend to hold more assets with higher risk and the potential for higher returns.

• Goal-based Asset Allocation

Goal-based investing is an approach to managing one’s finances and investments that focuses on achieving specific financial goals or life goals. 

Instead of aiming for high returns or following a generic investment strategy. 

Goal-based investing starts with identifying individual goals such as:

• retirement 
• buying a home 
• funding education, or 
• taking a dream vacation. 

Once these goals are defined, a tailored investment plan is created to meet these goals, considering factors like risk tolerance, time horizon, and the required rate of return. 

This approach helps investors stay focused on what truly matters to them and make informed financial decisions to reach their desired milestones.

2. Tactical Asset Allocation

Tactical asset allocation (TAA) involves adjusting the allocation of assets within a portfolio based on short-term market conditions and economic outlook. 

Unlike a long-term, passive approach, tactical asset allocation aims to utilise opportunities and mitigate risks. This strategy actively shifts investments between different asset classes, such as stocks, and bonds, among others, in response to changing market dynamics. 

This strategy allows investors to capitalise on potential market inefficiencies and adapt to prevailing economic conditions to optimize returns and manage risk.

Comparison between SAA and TAA

Here are a few comparisons between SAA and TAA:

Conclusion

In conclusion, these three asset allocation strategies provide diverse approaches to effectively manage risk and optimize returns within an investment portfolio. They can serve as stable, long-term strategies or as more dynamic, adaptable methods that respond to changing market conditions. These strategies serve as valuable decision-making tools for investors looking to enhance the performance of their portfolios.

FAQs

1. Why is asset allocation strategy important?

Asset allocation splits your hard-earned investments into different asset classes, offering the chance for higher returns and reduced risk through diversification. The variation in asset class movements highlights the importance of finding the right mix.

2. What is the historical performance of various asset allocation strategies?

Past performance can vary, but diversified strategies tend to provide more consistent returns over the long term.

3. How often should I review and rebalance my asset allocation?

Regularly review and rebalance your portfolio annually or when significant life changes or market shifts occur to maintain alignment with your financial goals.

4. What is the difference between SAA and TAA?

Strategic asset allocation (SAA) centers on the long term, whereas tactical asset allocation (TAA) concentrates on the short term. SAA relies on an investor’s risk tolerance, time horizon, and investment objectives, while TAA alters the asset percentage in response to market conditions.

5. What are the factors influencing asset allocation?

Factors influencing asset allocation include an investor’s risk tolerance, financial goals, time horizon, and market conditions. Additionally, factors such as age, income, and investment knowledge can also play a role in determining the optimal mix of assets in a portfolio.