4 types of asset allocation to ensure an optimal level of risk and return
However, did you know that there are different types of asset allocation strategies? Keep reading to find out.
Strategic Asset Allocation
This type of asset allocation adheres to a very practical static composition in terms of mutual funds. This gives the fund manager some flexibility to manage investments in different asset classes – say 75% in equities and 25% in debt. The fund’s mandate sets the asset allocation and the fund sticks to it.
Due to price movements, the actual asset mix may deviate from the fund’s mandate. The fund manager rebalances the portfolio and returns it to its original state. This asset allocation is similar to the strategy of buying and holding stocks and bonds.
It enforces discipline in investments and ensures that you won’t make bad decisions out of greed or fear. This is a long-term strategy, and you should go for it after considering your risk tolerance and investment schedule.
Tactical Asset Allocation
In the long term, a strategic asset allocation may seem too rigid. During your investment journey, market conditions may create opportunities to generate additional returns.
Having a strategic asset allocation may not help you seize this opportunity. This is where tactical asset allocation comes into play when you deviate from strategic asset allocation.
For example, suppose your strategic asset allocation requires you to maintain 70% equity and 30% debt.
Now, at any time, if you think equities can provide higher returns in the short term, you increase the equity allocation to 80% and hold it there until valuations of equities look too expensive. The additional 10% equity will increase short-term returns.
Tactical asset allocation, however, requires market timing. For this, you need considerable investment experience.
Dynamic Asset Allocation
In dynamic asset allocation, you adjust your asset allocation based on prevailing market conditions. With this strategy, you sell declining assets and buy rising ones.
Dynamic funds follow this strategy where the asset mix constantly oscillates between equities and debt.
Most funds increase their equity allocation when valuations are low and vice versa.
Some funds, however, increase the equity allocation in a rising market and reduce it in falling markets. Fund managers use different strategies such as P/E and P/B ratios to determine asset allocation.
Breakdown of insured assets
Assured Asset Allocation requires you to establish a base portfolio value below which your portfolio should not fall. As long as your portfolio generates returns above the base value, you deploy an active management strategy to maximize its value.
However, if the value goes down, you invest in risk averse assets so that the base value is fixed.
This type of asset allocation is suitable for investors who want some level of active portfolio management but do not want the value of their portfolio to fall below a certain value.
Asset allocation plays a crucial role in ensuring the optimal level of risk and return. When developing your asset allocation strategy, consider various factors such as your investment objectives, risk tolerance and time horizon. Investing in low correlation asset classes is the key to a successful plan.
(The author is President and Head, Personal Wealth, Wealth Management)