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Effective Asset Allocation Techniques

February 12, 2010

Asset allocation is the strategy used in choosing between the various kinds of possible investments. In other words, the strategy used for choosing which asset classes such as stocks and bonds one wants to invest in.


asset-allocation

A large part of financial planning consists of finding an asset allocation that is appropriate for a given person in terms of their appetite for and ability to shoulder risk.

Examples of asset classes:

  • Cash ( money market accounts)

  • Bonds: investment grade or junk (high yield); government or corporate; short-term, intermediate, long-term; domestic, foreign, emerging markets

  • Stocks: value or growth; large-cap versus small-cap; domestic, foreign, emerging markets

  • Real estate

  • Foreign currency

  • Natural resources

  • Precious metals

  • Luxury collectibles such as art, fine wine and automobiles

  • Real Estate Investment Trusts (REITs)

  • International Investments: Foreign or emerging markets

  • Life settlements.

What are the various Asset-Allocation Strategies ?

Dynamic Asset Allocation

One of the popular allocation schemes is dynamic asset allocation, with which one actively moderates the mix of assets as markets soar and falter. With this strategy one sells assets which are losing value and buys those assets which are gaining. This strategy can diametrically opposite to a constant-weighting scheme.

Strategic Asset Allocation

Strategic asset allocation is a strategy that establishes and sticks to what is called a ‘Base policy mix’. This is a proportional combination of assets based on expected rates for class of asset.

For instance, if the statistical data shows that stock-market has historically returned 20% per year and bonds have returned 10% per year,
a mix of 50% stocks and 50% bonds would be expected to return 15% (= 0.5 * 20 + 0.5 * 10) per year.

Constant-Weighting Asset Allocation

The Strategic asset allocation usually employs a Buy-and-Hold strategy, even though the variations in the actual worth of the assets cause a dramatic change in the initially established policy mix. For this reason, one might prefer to use a constant-weighting approach for asset allocation. In this scheme, one continually re-balances the portfolio.
For instance, if asset A were declining in value, one would purchase more of that asset, and if that asset value increases, then one would sell it.

There are no rigid rules for the frequency of portfolio re-balancing under strategic/constant-weighting asset allocation techniques. Although, a widely accepted norm is that the portfolio must be re-balanced to its original mix when any given allocated asset varies more than 5% in value.

Tactical Asset Allocation

Over the long run, a strategic asset allocation strategy does not allow much flexibility. So, one may find it useful to engage in short-term, tactical deviations from the mix in order to capitalize on the out-of-the-line
investment opportunities. This flexibility imparts a degree of market timing to one’s portfolio, letting one participate in economic conditions that are more suited to a particular asset class.

So, in some sense, Tactical asset allocation can be described as a moderately active strategy, since the overall strategic asset mix is returned to when desired short-term profits are achieved.

So that were the best asset allocation techniques. If you have any doubts or questions, do mention them in the comments box and we shall get back to you soon.

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