IN THE uncertain world of finance, we know that systematic investment and sticking to your asset allocation hold the key to success. But wealth management experts use asset allocation strategies not only to create wealth, but also to protect it during volatile times. It is not the maximisation of returns, but optimisation of returns that becomes the goal of money managers. Asset allocation strategy has to be reviewed continuously. This process plays a key role in determining the risk and return from your portfolio. Broadly speaking, the portfolio's asset mix should reflect your risk taking capacities and goals. Wealth managers use different strategies of building asset allocations and we outline some of them and examine their basic management approaches.
Strategic Asset Allocation
Strategic allocation is typically the first stage in the investment process. Based on the investor's long-term objectives, an initial portfolio is build. It is the backbone of any investment strategy. This often forms the basic framework of an investor's portfolio. This is a proportional combination of assets based on expected rates of return for each asset class. For example, if stocks have historically given a return of 12% per year and bonds have returned 6% per year, a mix of 50% stocks and 50% bonds would be expected to return 9% per year. Strategic asset allocation generally implies a buy-and-hold strategy. Strategic asset allocation defines the boundary of risk, and it is these boundaries that help control portfolio risk.
Constant-Weighting Asset Allocation
Strategic asset allocation has its drawbacks as it entails a buy-and-hold strategy even if a change in the value of assets causes a drift from the initially established policy mix. This has driven the wealth managers to resort to the constant weighting asset allocation. This strategy helps you to continuously rebalance your portfolio. For example, if gold was declining in value, you would purchase more of it to maintain its weightage and if its value increased you would sell it. There are no hard-and-fast rules for the timing of portfolio rebalancing under strategic or constant-weighting asset allocation. Most wealth managers are of the opinion that the portfolio should be rebalanced to its original mix when any asset class moves more than 5-7% from its original value.
Tactical Asset Allocation
Over the long run, a strategic asset allocation strategy may seem relatively rigid. There are investors who constantly want to seek returns out of market opportunities that arise. Hence, investment managers find it necessary to go in for short term tactical calls. Such tactical calls create room for capitalisng on unusual or exceptional investment opportunities. This is like timing the market to participate in the fluctuations and volatility that arise due to market conditions. While a strategic asset allocation is revisited once in six months, tactical asset allocations are visited every month. Tactical calls are on an ongoing basis. For example, shifting a part of the portfolio from large cap stocks to mid cap stocks to take advantage of the environment is a tactical call. "We restrict our tactical calls around 10% of the total portfolio and rest of the money is strictly governed by strategic allocation," said a wealth advisor with a foreign wealth manager. Tactical allocations being opportunistic in nature, wealth managers prefer to maintain clear time-based and value-based entry and exit points to ensure better risk management.
Guided And Optimised Allocation
This can be seen as the advanced version of tactical asset allocation. When tactical asset allocation aims to take advantage of temporary situations in the market, the concept of guided and optimised allocation believes in squeezing the last drop out at all times. By very nature, it is meant for a bit aggressive investor. Here 75% of the clients' portfolio could follow the original asset allocation, while 25% of the portfolio will explore opportunities where there could be chances of making higher return. So, investing in gold futures for a quick buck, or short-term corporate deposits offering higher rate of interest and such other opportunities remains on investors' lookout. Here you must continuously stay tuned with the financial markets. The strategy further demands you to take into account transaction costs as the investors turn hyper active in search of higher returns.
Dynamic Asset Allocation
For aggressive investors who want to ride momentum at times, managers recommend dynamic asset allocation. So, if the stock market is showing weakness, you sell anticipating a further fall. If it is going up, you buy anticipating a further rise. Here you constantly adjust the mix of assets as markets rise and fall. This is the opposite of constant-weighting strategy. As the entire portfolio is available for action, amateur investors may turn hyper active. Especially in the high volatile times, acting on all types of information can lead to high transaction costs. Also, the tax treatment of the returns turns to disadvantages if you churn your portfolio too much. In times of high volatility, when the markets may not move up or down much, dynamic asset allocation is not advisable for naïve investors. Depending on the type of investor you are, asset allocation could be active or passive. However investors should choose one keeping in mind their age, long term goals and risk taking capacity in mind.
