Strategic Asset Allocation

Apr 19, 2016 | Tony Byrne's View

shutterstock_154401089_edit3-2000x1325

Strategic asset allocation involves defining portfolio asset allocations from the outset, based on historical performance and volatility data over a representative period. This strategy follows the principles of Modern Portfolio Theory: a pioneering work that saw Harry Markowitz win a Nobel Prize in 1990.

When creating the portfolio, managers establish an asset mix based on the expected risk and return dynamics of each asset class. A wealth of historical statistical data shows how asset classes have performed during a variety of social, political and economic conditions. Managers use significant resources to review this data, focusing on the long-term returns and risks within each asset class.

Using this analysis, it is possible to create portfolios that provide the best balance of risk and reward. Graphically this is known as the Efficient Frontier.

Portfolios fitting tightly to the Efficient Frontier are termed ‘Efficient’ because they aim to achieve the highest possible expected rate of return for the specified level of risk.

Figure 1 (below) shows the relationship between risk and return as you move along the Efficient Frontier. While a portfolio above the Efficient Frontier is mathematically impossible, a portfolio below the curve is not. In fact, it is common in many do-it-yourself portfolios.

 

Strategic Asset Allocation

 

Holding a portfolio not professionally mapped to the Efficient Frontier could mean you inadvertently take a higher degree of risk than the potential return warrants. A rational person would prefer to take the minimum possible risk in pursuit of a particular level of return.

An almost infinite number of strategic portfolios are available to investment managers. So they will provide each investor with portfolios tightly mapped to the Efficient Frontier. This offers the best chance of achieving a desired return at the lowest possible risk.

Managers adopting this approach do not focus on exploiting short-term valuation opportunities caused by a change in sentiment towards different asset classes. Instead, they analyse the performance of different assets over the long term and build portfolios with a mix of assets that could deliver the best possible outcome for a given level of risk. When following this approach, asset allocations will only be changed where there is a significant shift in the long-term outlook of any particular asset class.

To preserve the portfolio’s risk and return characteristics, asset class mixes are typically rebalanced to the target weights at regular intervals, such as quarterly or half yearly. The process of rebalancing involves selling those assets that have outperformed and reinvesting the proceeds into assets that have under-performed, thereby retaining the original asset allocation.

Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.

Archives

Subscribe