What is asset allocation and why does it matter?
Asset allocation is fundamental to achieving investment goals. In fact, asset allocation is likely to have a bigger impact on the performance of a portfolio than the selection of individual investments.
Asset allocation is fundamental in seeking to achieving investment goals. In fact, asset allocation is likely to have a bigger impact on the performance of a portfolio than the selection of individual investments
The role of asset allocation in a portfolio
Asset allocation is the process of balancing risk and return in a portfolio by investing across different asset classes. The major asset classes include bonds, stocks and cash. We discuss the different asset classes in Series 4, Topic 2 - What are the major asset classes and how do they differ?
Maintaining a diversified portfolio can help investors prepare for shifts in the economy, providing potential to not only capture opportunities but also minimize risks of overconcentration.
Traditional asset allocation strategies seek to mitigate overall portfolio volatility by combining asset classes with low correlations to each other – that is, asset classes that don’t tend to move in the same direction at the same time.
For example, the correlation between U.S. stocks and bonds has been mostly negative for the past 15 years, as captured in the chart below.
The portfolio examples below help to illustrate the potential benefits of combining asset classes with low or negative correlations. The portfolio in scenario 1 is invested entirely in U.S. equities, while the portfolio in scenario 2 has a 60% allocation to equities and a 40% allocation to bonds. As you can see in the risk/return data presented, having more than one asset class with low or negative correlations to each other (equities and bonds) can help to lower volatility while still achieving solid growth.
The impact of globalization on correlation
In today’s market, asset class correlations have become less stable than many investors realize. Long-term trends such as globalization have driven correlations higher.
In addition, correlations may increase during periods of market turbulence. As a result, seemingly distinct asset classes appear likely to behave more similarly than many investors expect.
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This environment makes it more challenging to construct a truly diversified and resilient portfolio because assets that were previously unrelated can now represent exposure to the same risk factors. For more information on risk factors, refer to Series 4, Topic 3 – What is risk factor diversification?
Managing asset allocation
Professional investment managers typically approach asset allocation from two perspectives – strategic asset allocation and tactical asset allocation. By using both in combination, the manager is able to not only set the long-term course for the portfolio but also respond to short-term market drivers.
Strategic asset allocation, which provides the long-term focus for a portfolio, is based on three key factors: investment objectives, risk tolerance and time horizon. Depending on the return targets and the level of risk that can be tolerated, portfolios may be labeled as conservative, income & growth, growth or high growth. Below are examples of hypothetical portfolios showing percentage targets for different asset classes.
As markets are constantly changing, maintaining strategic asset allocation in a portfolio requires periodic rebalancing to maintain target allocations. In addition, an investor’s strategic asset allocation will likely change over time to reflect changing investment objectives, risk tolerance and time horizons. For more information, refer to Series 4, Topic 4 – Should asset allocation change over time?
Tactical asset allocation, on the other hand, uses active management to increase or decrease exposure to a certain asset class based on macro fundamentals, valuations and market movements. Tactical asset allocation operates to take advantage of short-term opportunities, complementing the strategic asset allocation direction.
A well-diversified portfolio may also invest in different investments within each asset class. For example, the equity allocation in a portfolio may include domestic and international equities across a number of sub-sectors. For more information, refer to Module 4, Topic 2 – What are the major asset classes and how do they differ?