Asset allocation is a strategy by which an investor or investment advisor manages a portfolio in certain pattern and maintains that percentages (%) of allocation in desired asset classes and reviews it at intervals and reallocates once the decided allocation changes. The asset classes includes stocks, bonds, mutual funds, real estate, gold, other commodities, etc.
For example, an investor maintains a 60:40 portfolio, wherein 60% of the assets are allocated towards stocks and remaining 40% towards bonds. For the purpose of simplicity, we have taken these two allocations.
The logic behind the asset allocation process revolves around the diversification of risk. Stocks are more volatile in nature as compared to bonds. Stock volatility many a times makes investors slightly uncomfortable with their investments. Bonds typically being less volatile, they often move in opposite direction over shorter periods thereby offsetting portfolio volatility even more.
The discomfort that is associated with the stocks portfolio, is one of the reasons, why investors choose to diversify their portfolio allocation in order to reduce portfolio volatility. One major reason for this diversification is their emotional or behavioural reactions towards the volatility of the portfolio and their corresponding impact on the portfolio’s performance. For example, after the recent Bloody Friday on the Brexit event, if there would be any novice investor, who is not well versed with the volatility of the stock market and would have invested in the recent month, after seeing the stock market going down by 1000 pts in intra-day and later closing for the day by -600 pts. That investor would have become uncomfortable with his portfolio and may have thought of getting out of the investments looking at the negative portfolio values.
Moreover, after markets have fallen and market prices are depressed, negative sentiment abounds and many investors cut their losses and move to the sidelines.
Unfortunately, these reactions occur after markets have already moved and the typical result is a buy high/sell low strategy. This is a recipe for dismal investment performance. In this light, reducing the volatility of the portfolio by diversifying the portfolio can avoid the emotional reactions of the investors and avoid the temptations of reshuffling the portfolios at regular intervals (which instead of helping spoils the portfolio strategy) and in turn dampening the portfolio performance.
Asset allocation strategies vary in multiple dimensions. The first and most obvious variation related to how much (if any) to allocate to various asset classes. In general, investors with longer time horizons and higher risk take ability will allocate higher percentages to stocks and equity mutual funds.
The percentage allocations can be static or dynamic through the time. Genrally investors prefer static asset allocation and stick to it through ups and downs of the market volatility. Other investor prefer an approach whereby they specify ranges instead of precise levels. This allows their investment managers to exploit tactical strategies to take advantage of potential market opportunities.
Another important detail relates to how often asset allocations are brought back within their required ranges. Many investors follow a time-based approach whereby allocation are adjusted, may be quarterly or annually. Other investors follow thresholds or buffers to trigger rebalancing.
The benefits of asset allocation is diversification. By diversification we are trying to reduce the risk level of the portfolio. However, the real price that the investors pay for diversifying their portfolios via asset allocation strategies is not. Over a long term investment horizon, equities have outperformed bonds and most expect (including) the case going forward too.
So it is very important for the investors to understand their risk taking capability and appetite and accordingly trust their investment advisor and invest accordingly. As they say, “In investing, what is comfortable is rarely profitable.”