What is Asset Allocation?

A successful investment depends on three key steps: a sound investment plan, excellent planning execution, and the discipline to follow the plan. A sound investment plan is like a blueprint or roadmap to investors, and asset allocation is an earlier decision in creating the map and it simply refers to a mixture of asset classes.
What is the goal of asset allocation? An ideal portfolio is able to mitigate risks at desired return, lower the frequency of loss, and reduce the maximum drawdown. There is no free lunch in investing. The investment risk cannot be entirely eliminated, but an optimal risk-adjusted return portfolio can be achieved by adding more asset classes with different risk characteristics. 

The consensus among investment professionals is that asset allocation might be the most important element of a portfolio. In BHB’s study 1 (1986), asset allocation explained about 90% of a portfolio’s variability (in other words: return). Ibbotson and Paul D. Kaplan’s research 2 (2000) and Vanguard report 3 (2007) indicated the similar conclusion. The conclusion of the researches attributed a portfolio’s return variability to static asset allocation, neither security selection or market-timing.

History shows that S&P 500 lost approximately 50% and US real estate was down more than 60% before. Such losses in one single asset class are worse than investors’ anticipation. How to manage the portfolio risk is a challenging task of asset allocation.

Why Asset Allocation Works

Let every man divide his money into three parts, and invest a third in land, a third in business and a third let him keep by him in reserve." Talmud (ca. 200 BC)

The history of systematic approach of asset management is not long. In 1952, a 25-year old graduate student Harry Markowitz from the University of Chicago wrote an article entitled “Portfolio Selection”4. The 14-page paper changed professionals and institutional investors’ way to manage a portfolio and the concept of risks. The standpoint is the degree of risk can be mitigated via diverse investing. For example, in equity investment, there are two set of risks in a stock: market (beta) risk and individual risk. You can reduce risks associated with individual stocks by adding more stocks. The lowest risk combination is to include every stock in the market. The mathematical method can maximize return given a certain level of risk. In 1990, Markowitz is awarded the Noble prize for developed of the portfolio theory.
Asset allocation is a useful strategy in a portfolio with two and more stocks, and is more useful in a portfolio with two or more asset classes. The main objective is to resolve excess volatility problem of an investment outcome. Adding asset classes to the portfolio will move the efficiency frontier higher, which means better than holding only a few assets. It is more efficient to achieve the investment goal using a portfolio with lower volatility and higher expected return.

How to exercise Asset Allocation

There are some factors to consider in asset allocation: time intervals, risk tolerance, and individual investor’s restrictions. Basic types of asset allocation:

  • Strategic Asset Allocation
  • Strategic asset allocation is to construct a portfolio with a long-term consideration, usually 5 to 10 years. In practice, every one to three years, an evaluation of investor’s change in financial situation and preference will be performed by the investment manager. The methods of implementation of strategic asset allocation are:

    • Buy and hold
    • Constant Mix
    • Insured Asset Allocation
  • Tactical Asset Allocation
  • Tactical asset allocation aims to take current market opportunities to enhance the return. When a desired short-term return is achieved, the portfolio will return to its long-term strategic allocation mix. Tactical asset allocation can be described as an active strategy, same as dynamic asset allocation.

Who should use asset allocation

Theoretically or empirically speaking, asset allocation is proven the most efficient investment strategy to keep or achieve capital growth. One single asset class may result in a large fall in value, so any rational investor should divide his or her portfolio into asset classes. The allocation strategy of a one million or one billion portfolio may be different, but the theory is the identical. In the investment market, you cannot obtain a desired return without taking certain risks. Asset allocation is to help investors follow their blueprints and achieve the desired investment goal without taking excess risks.

2 www.mangustarisk.com/doc/pdf/Does_Asset_Allocation_Explain_40_90_100_Performance.pdf
4 https://en.wikipedia.org/wiki/Harry_Markowitz


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Published on 10 August 2019