Clear goals + Smart choices = Better life
This formula is essentially what people live by (or at least, strive to) no matter what career or path they are in — even students. Having clear goals, either for today or tomorrow, helps you make smart and responsible choices that lead to a better life. And this formula, surprisingly, is also very much applicable to your investment journey. making smart choices directed by clear objectives leads to a better investment journey for you — both emotionally and financially. These objectives include your expected return after some time. Having a smoother investment journey definitely guarantees you a better life.
But, how do we do it? Asset Allocation.
If you’ve read our previous article on risk profiling (if you haven’t yet, check it out here), you would remember that we’ve discussed the importance of knowing thyself as an investor. The next step to realizing your journey as an investor is to plan out a framework for your investment portfolio. There’s no better way to do this than knowing what asset allocation strategies would work best for you.
To start, asset allocation is the strategy that an investor implements — by appropriating an asset mix best suited to the investor — as an attempt to balance risk and reward, most especially to lower the volatility of an investor’s portfolio. It’s simply how you plan to distribute your capital among all the asset classes you plan to invest in. Think of it as the skeleton by which investors base their choices and actions throughout their investment journey. And an asset allocation strategy pertains to how you manage or handle your asset mix.
Before we move on to the specifics, we must first discuss diversification and its relationship to asset allocation. These two terms are often mistaken as synonyms and consequently used interchangeably. Diversification is a risk management strategy rooted on the concept of the Efficient Frontier (learn more about the efficient frontier by reading this article) and its main goal is to create a portfolio with negatively correlated (or in simpler terms, inversely related) or imperfectly correlated assets at the very least, to minimize exposure to risk. You’ve probably heard the saying “don’t put all your eggs in one basket” and this is essentially what diversification is about. It capitalizes on the fact that there are asset classes, industries, companies, and even countries that respond differently to changing market conditions. For example, in the Philippine setting, while the services and tourism sector is heavily affected by the COVID-19 pandemic, the logistics sector, on the other hand, is experiencing a boom. With this in mind, having investments in both industries (i.e., stocks) offsets the negative impact of the current downtrend in the services and tourism industry with the promising uptrend in the logistics industry, thereby reducing the risk of losses or achieving less than your expected returns.
Diversification is different from asset allocation in that it does not primarily concern itself with your distribution of capital, but focuses more on what and where you are putting your funds in. To help you visualize, imagine yourself buying an assorted box of donuts. Choosing what flavors to buy is considered diversification. Assume that a box of donuts is limited to a dozen pieces and you only have enough money for a box. Choosing how many of each flavor you are going to buy is asset allocation.
Factors typically considered in diversification are industries, companies, and countries among many others. While diversification has a lot of advantages, we advise you not to get carried away! Over-diversifying your portfolio will eventually reduce your potential returns. Recall that risk and return have a positive correlation which means that the higher the risk the higher the returns while the lower the risk the lower the returns. Because you are basically trying to lower your portfolio’s risk when you diversify, you are also minimizing your expected returns. While lowering risk is ideal, it sacrifices your portfolio’s return in the long-run. You must learn to strike a balance between the risk you can take and the return you want to achieve. Going back to our donut example, imagine that you chose to buy a piece of 12 different flavors. The return you expect from buying donuts is to satisfy your cravings, yes? Imagine yourself trying the cream cheese flavor and eventually loving it more than the others you put in, but you can’t reach out for the same flavor again because you had 12 different kinds of donuts in your box. Do you think you’d be as satisfied as you would be if you had at least one more of the cream cheese donut in your box? Nope. This is what over-diversifying is trying to say, that your actual returns may not be at par with your expected returns when you diversify your portfolio too much. Putting diversification and asset allocation together will help you achieve a smoother and better investment journey.
Below we’ve outlined 5 asset allocation strategies that we thought you should know.
1. Tactical Asset Allocation
Also known as TAA, Tactical Asset Allocation is the strategy of actively managing a portfolio, in which asset allocations constantly shift based on macroeconomic events — i.e., the market trends or economic status of a country. Investors that practice this strategy start out by implementing an initial asset mix that may change depending on whether or not it manages to achieve the returns expected of it. Adjustments in asset classes in one’s portfolio are done in response to the aim of taking the opportunity the market presents. In this way, investors boost their portfolio returns by taking advantage of a market’s good performance while dodging potential losses or decrease in yields due to poor market conditions (such as a recession). This style or strategy entails that investors must be flexible, active, and knowledgeable (which means that not only do you have a lot of market insight but experience as well) because TAA is flexible and values market-timing in adjusting the proportions in favor of what asset class is performing better. Keep in mind that this strategy is not only applicable to shifts in asset classes but also within an asset class.
For example, Investor Jeff Aye established an initial asset mix of 60% in stocks, 30% in bonds, and 10% in money market funds. After a few months, Jeff observed that the asset mix’s performance was not up to par with his expectations, he then believed (after tedious research and study of the market) that the Philippine economy will enter a recession soon. What this strategy tells Jeff to do is to shift the asset mix to minimize his losses in the stock market and protect his capital. Jeff sells some of the stocks, purchases short-term bonds and invests in money market instruments more, thereby shifting his asset mix to 20% stocks, 65% bonds, and 15% money market funds. This asset mix will eventually have to change again when the Philippines economy rises up from the recession.
2. Strategic Asset Allocation
Also known as SAA, Strategic Asset Allocation is based on the Modern Portfolio Theory (read more about the Modern Portfolio Theory here) which assumes that markets are efficient. SAA requires you to determine what asset classes (and its subclasses) you will invest in and how much of your funds go into which asset class and subclass. Whatever proportions you decide on, you maintain and adhere to for the long-term (wow, the commitment!). For this strategy, you need to account for several factors but the three main factors that you need to take into consideration are your risk tolerance, investment timeframe, and goals or expected returns. In contrast with TAA, this asset allocation involves a passive investing approach and is very ideal if you are an investor that prefers a “buy-and-hold” or “hands off” approach to your investment as well as an emotional one. This strategy ensures that you prevent making impulsive decisions such as selling equities when the market’s performance suddenly drops or buying short-term bonds or treasuries when the yield curve inverts. Although the premise involves holding the proportions constant for a long-time, periodic rebalancing may be necessary and is totally acceptable, especially when accounting for unrealized gains or losses!
For example, Investor Roy is an aggressive investor and plans to invest until he retires — 40 years from now. He then decided to establish a 75% stock, 20% bonds, and 5% cash asset mix. What SAA tells him to do is to hold this asset mix for 40 years. He can only rebalance this portfolio when, for example, 10 years before he retires he saw that his portfolio’s asset mix changed to 60% stock, 35% bonds, and 5% cash due to bonds performing well and giving returns higher than he expected. This strategy entails that he sells 15% of the bonds and reinvest it in stocks even if the bond market is performing well to maintain his original asset mix. Remember that this strategy does not value reacting to current market conditions.
3. Constant-weighting Asset Allocation
The Constant-weighting asset allocation strategy is an approach that employs the need to continually rebalance your portfolio to maintain the original asset mix established. For example, a decline in an asset’s value means that one should purchase more of that asset while an increase in its value leads you to sell it. Rebalancing your portfolio may stem from a change in macroeconomic conditions or movement to a life stage such as getting married or retiring. This is different from SAA (strategic asset allocation) in that while SAA relies on the market’s efficiency — which is why it’s considered as a passive strategy — while still generally maintaining the pre-established asset mix, constant-weighting asset allocation allows active and constant adjustments to meet your original asset mix. The rule of thumb that most investors and portfolio managers follow for this strategy is: A > 5% deviation from an asset class’s original value or proportion calls for a rebalancing.
For example, Investor Icy has a pre-established asset mix of 60% stocks, 30% bonds, and 10% cash. A few weeks into the market, stock prices increased, changing the asset mix to 64% stocks, 27.5% bonds and 7.5% cash. What this strategy tells Icy to do is to keep his current portfolio as is because deviations are less than 5%. Let’s say that a month after that, his asset mix became 66% stocks, 26% bonds, and 8% cash. Because stocks deviated by 6% from its initial asset mix, what Icy would do is to sell his stocks to return it’s proportion to 60% because an increase in the stocks’ value requires that they sell it and reinvest in both bonds and cash whose values are declining to achieve his original asset mix.
4. Dynamic Asset Allocation
Dynamic Asset Allocation (DAA) is an allocation strategy where an investor constantly adjusts their asset mix. Unlike TAA, there is no pre-established asset mix for this one and the asset mix is simultaneously adjusted to the market’s highs and lows and the economic health of a nation or industry. Because the asset mix is constantly adjusting, this is considered an active allocation strategy. This strategy is the polar opposite of the constant-weighting allocation strategy because it practices selling when the market is performing poorly to stop your portfolio from decreasing its value, and buying in a market rally when stocks for example are anticipated to increase in value or price.
For example, Investor Trey Dee entered the market with an allocation of 65% stocks, 35% bonds, 10% cash. The next day, stocks began increasing in price due to the positive outlook of investors with the news of a vaccine soon to be approved. What this strategy tells Trey to do, is to continue buying stocks even if the prices increase. The next day his new asset mix will become 75% stocks, 20% bonds, and 5% cash. This asset mix will constantly change with the market.
5. Insured Asset Allocation
Lastly, Insured Asset Allocation (IAA) is a strategy that establishes a baseline value for each asset class (and subclass) from which your portfolio is not allowed to fall. In the event the portfolio drops below its predetermined level, the investor reallocates assets to avert the risk. As long as the asset classes in the portfolio’s value manage to be above the minimum threshold, then the investor is free to decide however they want to handle their portfolio or particular investments. This means that the investor can buy, sell, or hold their investments to their own liking. This asset allocation strategy is ideal for risk-averse investors as it offers the security of still getting positive returns or portfolio value above the baseline while allowing them to actively take charge of their investments. If you are risk-averse but still desire to actively participate in the market, then you might want to consider this strategy.
For example, Investor Mark Keith is risk-averse. He established a baseline value of 40% in stocks, 20% in bonds, and 15% in cash (Note: The baseline value or proportion does not necessarily need to equate to 100%). He started investing in 45% stocks, 30% bonds, and 25% cash. As long as his investments’ value does not fall below the baseline, Mark is free to buy and sell any asset class to his own liking. If it does fall for example, with stock going down to 39%, he will avert the risk by investing in risk-free assets such as T-bills and then reallocating his asset mix.
Alright, we’ve gone through five asset allocation strategies (among many others) but why do we need to know this? You see, asset allocation plays an important role in determining the success of an investment portfolio. It’s undoubtedly, one of the most significant decisions you have to make in your investment journey. Remember the formula mentioned at the beginning of this article? Yes, that. It implies that your portfolio will only be optimized to give you maximum rewards with minimum risk to achieve your goal if you make smart choices and a framework that guides you through it. The asset allocation strategy you plan to employ will help you do just that. Never forget that the best way to allocate your assets is a personal preference and choice and is dependent on several factors. Given this, your asset allocation might change and it’s okay! Why? Because people change — you age, your financial capabilities change, your temperament changes, your goals evolve.
Remember, asset allocation is personal and thus it must adapt to you. Though devising your framework strategy is a matter of personal preference and is relatively straightforward, the key to a successful asset allocation strategy is its implementation. Thus, it’s important that you master the art of discipline.
If you’ve read this far, congratulations! Give yourself a pat on your back or eat your favourite snack (maybe a donut?) because you deserve it. You can also visit UP JFA’s Pisopedia to learn more. See you next Saturday!💚
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