If I asked you what strategic asset allocation in finance is, would you be comfortable explaining it to me? For many, the answer is no, but don’t despair. In this blog post today, I will take a simplified approach to explaining asset allocation.
What Is Strategic Asset Allocation?
Asset allocation is an investment strategy that aims to reduce risk and increase the reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance, and investment horizon.
A simpler way to say it is that strategic asset allocation in finance spreads your investments over various types of assets to guard against changes in the market. It’s kind of like a way to hedge your assets over time.
What Are the Key Asset Classes?
First are stocks, which are quite self-explanatory. The second is fixed-income assets like bonds. There is cash to the equivalent of money market accounts.
Next, for advanced investors, there are features, derivatives, side notes, and assets like real estate. Most of the meat of a portfolio is equity stocks and fixed income assets.
What are the most common assets in portfolios? Most of the meat of a portfolio is equity stocks and fixed income assets. Before your shift and adjusting your portfolio, you should consider three key things in strategic asset allocation.
Things to Consider for Portfolio Design
Your Personal Goals
First, your personal goals. I use your personal instead of finance, as you should think holistically when designing your ideal portfolio. Where do you want to be in five, ten, or 15 years? Where do you see yourself? What do you see yourself doing? Answering all these questions will help you design a better portfolio.
Your Time Horizon
Next is your time horizon. When do you need this money, and where do you plan to reach financial independence? Do you plan to quit your job soon? Outlining your timeline is key to a better understanding how to design your portfolio.
Your Risk Tolerance
Lastly, consider your risk tolerance. I would say this is where individualism comes in. For example, some people are sitting on just a one-month emergency fund, while others have over 12 months of savings. I think about how much risk I can tolerate and adjust accordingly.
Think of Your Portfolio as a Pie
Yes, a pie. If you picture a pie chart, imagine one piece of the pie as stock equities and some of its bonds. When you hear people say things like, Oh, I have an 80/20 portfolio, I have a 70/30, or a 50/50 portfolio. We’re not talking about somebody’s eyesight being poor when using those numbers.
We’re talking about the actual strategic asset allocation; that’s how much we allocate to equities (stocks), usually first, and bonds. When we say bonds or fixed income, everything from cash to CDs to bond-type investments is inside your portfolio.
Why Own Both Stocks and Bonds in a Portfolio
We own stocks and bonds in a portfolio because they move at different times in different directions at different rates.
So we might have a period where our 70% stocks in our portfolio do well. These equities are performing at an all-time high, and now they’re taking up 80% of our portfolio.
Well, big problem; we now take on more risk than we originally intended. This is because you have more money in the more volatile equities (stocks) than we have in bonds. As a result, strategic asset allocation can help balance that.
The Solution to an Outbalanced Portfolio
Well, we must rebalance the ratio of stocks to bonds. And when we rebalance it, here’s what I want you to think about. We’re selling high and buying low, meaning the stocks outperform the bonds.
Or maybe selling the stocks relatively high to buy the relative low of the month. And so, over time, stocks can go down; they go the other way.
Now let’s say stocks make up only 60% of our portfolio and bonds make up 40%. Now we will sell some of that fixed income portion of the bonds, which will go into the stocks. Effectively, we’re selling high and buying low.
Can’t we buy low and sell high? Now everybody talks about the fact that what you should be doing is buy low and sell high. That’s a secret of the stock market. Except that the secret is not easily obtained. No academic evidence shows anybody can predict when to buy and sell stocks.
What is one solution to the unpredictability of the stock market? We can consistently move money between fixed income and stocks because they move differently.
So we can sell high from the portion of our portfolio that does well and buy low from the portion of our portfolio that does not. This is strategic asset allocation.
Asset Allocation vs Individual Securities
The last 15 years are a great testament to why it’s important to do this. Let me emphasize this: the selection of individual securities is secondary to how assets are allocated in stocks, bonds, cash, and other offerings, which will overall determine your investment results.
I don’t think there is one, as everyone’s personal goals differ. Think about the young investor starting at 20 and happy with working until 65. He will need a different strategic asset allocation than the person who didn’t start investing until 40 and wants to retire at 65.
Final Thoughts: Strategic Asset Allocation
As you age, you must continue to balance and adjust your portfolio. Planning for retirement can be challenging, but it doesn’t have to be. But if you keep abreast of the market, you should be able to make smart choices that maximize your ability to hit your retirement goals with strategic asset allocation.
Frequently Asked Questions
What Is an Allocation in Finance?
It’s dividing your investment portfolio among different asset classes.
What Are the 4 Types of Asset Allocation?
They are strategic, dynamic, tactical, and core-satellite.
What Is the Difference Between Strategic and Tactical Asset Allocation?
Strategic asset allocation is for long-term investing. Tactical is for the short term.
What Are Asset Allocation Strategies?
Diversify your portfolio by dividing it between stocks, bonds, and cash.