Forms of Asset Allocation

Asset allocation refers to the creation and implementation of an investment strategy towards balancing risk and reward.

Asset allocation refers to the creation and implementation of an investment strategy towards balancing risk and reward. To do so, investors are required to adjust the percentage of assets being given to specific asset types or securities based on the investor's risk tolerance, goals and investment time frame. Here are some of the different forms of asset allocation:

Strategic Asset Allocation

This is an enhanced form of buy-and-hold strategy that involves allocating certain percentages of your funds to asset classes and maintaining/balancing those percentages annually.

For example, if you invested 60 percent of your fund in stocks and 40 percent in fixed-income assets, you’d maintain that percentage and balance your portfolio to reflect it every year.

Another example, Yemi has ₦200,000 in an investment fund and allocates 60 percent to stocks and 40 percent to fixed-income assets. At the end of the first year, his stocks made a return of 10 percent, while his bonds made a return of 7.5 percent.

At this point, Yemi’s stocks are worth ₦132,000 and his bonds are worth ₦86,000. His portfolio is now worth ₦218,000 comprised of 60.55 percent stocks and 39.45 percent bonds. Yemi must now maintain his 60/40 allocation by selling 0.55 percent stocks and adding it to the bonds. This is called balancing a portfolio.

Tactical Asset Allocation

This is a more hands-on approach to managing your portfolio. While strategic allocation can be effective in the long-run, it does not accommodate unusual or short-term changes in the market.

For example, the stock market may be down but cash equivalents and commodities may be up. If your allocation was 60 percent stocks and 40 percent cash equivalents and you were using the strategic model, then you wouldn’t be able to take advantage of the current market situation.

With tactical allocation, you can adjust your percentages based on short-term market opportunities. For example, say you have 60 percent in stocks, 30 percent in bonds, and 10 percent in commodities. Imagine international trade relations make the commodities market more profitable for a short period.

With strategic allocation, you wouldn’t be able to benefit from this short-term rise. But with tactical allocation, you can adjust your percentages, allotting more to commodities.

Investors that use this strategy should be able to tell when a short-term opportunity has run its course. Tactical allocation can also be done within one asset class. For example, a 60 percent investment in stocks can be subdivided into 30 percent in large-cap stocks and 30 percent in small-cap stocks.

Insured Asset Allocation

This strategy sets a base value below which a portfolio is not allowed to drop. As long as the portfolio stays above that value, you can employ whatever methods and rules to grow the portfolio.

Dynamic Asset Allocation

This is a variant of the tactical asset allocation strategy, but, unlike the former, it involves adjusting your percentages and asset classes with the rise and fall of the market. This strategy is very hands-on (more hands-on than the tactical strategy) and relies on expert knowledge of the various asset markets.

In our next post, we will consider some general rules of thumb that guide asset allocation.

Written by Lawretta Egba.