Asset Allocation Models, Strategies and Pitfalls
Abstract
This article explores asset allocation's critical role in distributing capital among various classes, impacting portfolio risk and return. It covers established methods like Mean-Variance Optimization, Risk Parity, Asset-Liabilities Allocation, Objective-Based Allocation, and Naive-Based Allocation. The study also addresses temporal aspects, discussing strategic and tactical asset allocation and the Core-Satellite approach. Common pitfalls, such as insufficient diversification and irregular rebalancing, are outlined, emphasizing the importance of considering life stages and seeking professional advice. The aim is to provide a concise guide for investors navigating the complexities of asset allocation.
Time to read: 8 to 12 minutes.
Level: Fundamental.
Category: Education Note.
Asset Allocation: Methods and Models Explained
Asset allocation is the process of distributing capital among different asset classes, such as stocks, bonds, commodities, and cash. It stands as one of the most crucial decisions in portfolio management, shaping the overall risk and return characteristics of the portfolio.
A landmark study on asset allocation is Brinson, Hood, and Beebower's (1986), which found that differences in asset allocation policies among funds explained 93.6% of the variance in their total returns. This implies that choosing asset classes is more impactful than selecting individual securities within each class. This discovery was later reinforced by subsequent studies, including those by Brinson, Singer, and Beebower (1991) and Ibbotson and Kaplan (2000).
However, asset allocation is not a static decision made once and forgotten. Asset classes have varying expected returns and risks, which can change over time due to market conditions, economic factors, investor preferences, etc. Therefore, asset allocation needs periodic review and adjustment to reflect the current and expected environment, as well as investor goals, risk tolerance, and time horizon. This dynamic or tactical asset allocation can enhance portfolio performance and reduce risk.
Various methods and models exist to determine the optimal asset allocation. Some frequently used methods include:
Mean-Variance Optimization: Based on Markowitz's (1952) Modern Portfolio Theory, this method aims to maximize expected return for a given level of risk or minimize risk for a given level of expected return. It considers expected returns, standard deviations, and correlations of asset classes, as well as the investor's risk aversion coefficient.
Risk Parity: This strategy aims to balance the risk contributions of different asset classes, seeking a more stable and diversified portfolio performance regardless of market conditions. It relies on historical data and volatility measures to allocate assets based on their risk profiles.
Asset-Liabilities Allocation: Grounded in the asset and liability management approach, this method considers not only assets but also the investor's liabilities. The goal is to match the duration, cash flows, and risk characteristics of assets with those of liabilities, reducing the risk of deficit or surplus in meeting obligations.
Objective-Based Allocation: Drawing from behavioral finance, this approach recognizes investors' multiple and sometimes conflicting goals, such as saving for retirement, education, or travel, each with different time horizons and risk profiles. The aim is to create a portfolio (or multiple portfolios) that can meet each goal with a high probability, considering investor preferences, emotions, and biases.
Naive-Based Allocation: This simple approach involves equally allocating funds among different asset classes without considering expectations about returns, risks, or correlations. While criticized for its simplicity, it may be close to optimal in certain cases, especially when assets have similar returns and low correlations.
How to Deviate from Your Asset Allocation Strategy
In terms of time considerations, deviations from a specific asset allocation are often employed to seize opportunities or mitigate risks, with two common approaches being:
Strategic and Tactical Asset Allocation: Strategic asset allocation involves setting a long-term asset mix based on risk tolerance and performance goals. Tactical asset allocation, on the other hand, involves adjusting the portfolio composition in response to short-term market conditions and opportunities. While tactical asset allocation can enhance performance by exploiting market inefficiencies, it also comes with higher costs, risks, and complexity compared to strategic asset allocation.
Core-Satellite Asset Allocation: This strategy combines a large and diversified portfolio of low-cost index funds (the core, typically 60-80% of the portfolio) with a smaller number of actively managed funds or individual securities (the satellites, typically 20-40% of the portfolio) aiming to enhance returns or reduce risk. While offering benefits such as lower costs, tax efficiency, diversification, and flexibility, the basic core-satellite asset allocation may not be a one-size-fits-all solution and may not perform well in certain market conditions or for certain investors.
Asset Allocation: How to Avoid Common Mistakes
Asset allocation comes with challenges that individual investors should avoid. Common mistakes include:
Insufficient Diversification: Investing in only one or a few asset classes can expose the portfolio to unnecessary risks and volatility. Diversification across and within asset classes is essential to mitigate the impact of market fluctuations and specific events.
Irregular Rebalancing: Asset allocation is not a one-time decision. Over time, the investment portfolio can deviate from its target allocation due to market movements and changes in investor goals and risk tolerance. Regular portfolio review and rebalancing are necessary to maintain the desired level of risk and return.
Ignoring Life Stages: Asset allocation should align with the time horizon, income needs, and risk tolerance. As one ages, a shift to lower-risk assets like bonds and cash may be desirable to preserve capital and generate income. Tax situations and liquidity needs should also be considered when allocating assets.
Lack of Professional Advice: Asset allocation can be complex, especially for individual investors lacking time, knowledge, and resources. Seeking guidance from a professional advisor, financial planner, or investment manager can help design and implement an asset allocation strategy that suits an investor's goals and circumstances.
References:
Maginn, John L., Donald L. Tuttle, Jerald E. Pinto, and Dennis W. McLeavey, eds. Managing Investment Portfolios: A Dynamic Process. 3rd ed. Hoboken, NJ: John Wiley & Sons, 2007.
Recommended Readings:
Bernstein, William J. The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk. New York: McGraw-Hill, 2000.
Malkiel, Burton G. A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing. 12th ed. New York: W. W. Norton & Company, 2020.
Faber, Mebane T. Global Asset Allocation: A Survey of the World’s Top Asset Allocation Strategies. 1st ed. New York: CreateSpace Independent Publishing Platform, 2015.
Tag Words
Investment Wisdom, Financial Success, LongTerm Perspective, Risk Management, Diversification, Investment Policy, Behavioral Finance, Portfolio Management, Financial Goals, Investment Strategy, Asset Allocation, FinancialDiscipline.
