Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment time frame. The focus is on the characteristics of the overall portfolio. Such a strategy contrasts with an approach that focuses on individual assets.
Description
Many financial experts argue that asset allocation is an important factor in determining returns for an investment portfolio. Asset allocation is based on the principle that different assets perform differently in different market and economic conditions.
A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. Because correlations between asset classes may change over time, diversification can reduce portfolio volatility but cannot eliminate market risk or guarantee positive returns. Asset diversification has been described as "the only free lunch you will find in the investment game". Academic research has painstakingly explained the importance and benefits of asset allocation and the problems of active management (see academic studies section below).
Although the risk is reduced as long as correlations are not perfect, it is typically forecast (wholly or in part) based on statistical relationships (like correlation and variance) that existed over some past period. Expectations for return are often derived in the same way. Studies of these forecasting methods constitute an important direction of academic research.
When such backward-looking approaches are used to forecast future returns or risks using the traditional mean-variance optimization approach to the asset allocation of modern portfolio theory (MPT), the strategy is, in fact, predicting future risks and returns based on history. As there is no guarantee that past relationships will continue in the future, this is one of the "weak links" in traditional asset allocation strategies as derived from MPT. Other, more subtle weaknesses include seemingly minor errors in forecasting leading to recommended allocations that are grossly skewed from investment mandates and/or impractical—often even violating an investment manager's "common sense" understanding of a tenable portfolio-allocation strategy.
==Asset classes== An asset class is a group of economic resources sharing similar characteristics, such as riskiness and return. There are many types of assets that may or may not be included in an asset allocation strategy.
Traditional assets The "traditional" asset classes are stocks, bonds, and cash: Stocks: value, dividend, growth, or sector-specific (or a "blend" of any two or more of the preceding); large-cap versus mid-cap, small-cap or micro-cap; domestic, foreign (developed), emerging or frontier markets Bonds (fixed income securities more generally): investment-grade or junk (high-yield); government or corporate; short-term, intermediate, long-term; domestic, foreign, emerging markets Cash and cash equivalents (e.g., deposit account, money market fund) Allocation among these three provides a starting point. Usually included are hybrid instruments such as convertible bonds and preferred stocks, counting as a mixture of bonds and stocks.
Alternative assets Other alternative assets that may be considered include: Valuable economic goods and consumer goods such as precious metals and other valuable tangible goods. Commercial or residential real estate (also REITs) Collectibles such as art, coins, or stamps Insurance products (annuity, life settlements, catastrophe bonds, personal life insurance products, etc.) Derivatives such as options, collateralized debt, and futures Foreign currency Venture capital Private equity Distressed securities Infrastructure
Allocation strategy
There are several types of asset allocation strategies based on investment goals, risk tolerance, time frames and diversification. The most common forms of asset allocation are: strategic, dynamic, tactical, and core-satellite.
Strategic asset allocation The primary goal of strategic asset allocation is to create an asset mix that seeks to provide the optimal balance between expected risk and return for a long-term investment horizon.Idzorek, Thomas M., "Strategic Asset Allocation and Commodities", Ibbotson Associates, 27 March 2006, Morningstar, Inc. Generally speaking, strategic asset allocation strategies are agnostic to economic environments, i.e., they do not change their allocation postures relative to changing market or economic conditions.
Dynamic asset allocation Dynamic asset allocation is similar to strategic asset allocation in that portfolios are built by allocating to an asset mix that seeks to provide the optimal balance between expected risk and return for a long-term investment horizon. Like strategic allocation strategies, dynamic strategies largely retain exposure to their original asset classes; however, unlike strategic strategies, dynamic asset allocation portfolios will adjust their postures over time relative to changes in the economic environment.
Tactical asset allocation Tactical asset allocation is a strategy in which an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for perceived gains.Blitz, David and Van Vliet, Pim, "Global Tactical Cross-Asset Allocation: Applying Value and Momentum Across Asset Classes", The Journal of Portfolio Management, Fall 2008, pp. 23–28.Faber, Mebane T., "A Quantitative Approach to Tactical Asset Allocation", The Journal of Wealth Management, Spring 2007. While an original asset mix is formulated much like strategic and dynamic portfolio, tactical strategies are often traded more actively and are free to move entirely in and out of their core asset classes.
Core-satellite asset allocation Core-satellite allocation strategies generally contain a 'core' strategic element making up the most significant portion of the portfolio, while applying a dynamic or tactical 'satellite' strategy that makes up a smaller part of the portfolio. In this way, core-satellite allocation strategies are a hybrid of the strategic and dynamic/tactical allocation strategies mentioned above.Singleton, J. Clay, Core-Satellite Portfolio Management: A Modern Approach for Professionally Managed Funds, McGraw-Hill 2004
Classification Industry sectors may be classified according to an industry classification taxonomy (such as the Industry Classification Benchmark). The top-level sectors may be grouped as below:
Morningstar X-ray Defensive Consumer Staples Health Care Utilities Sensitive Energy Industrials Technology Telecommunications Cyclical Consumer Discretionary Basic Materials Financials Real Estate
Per the Tactical asset allocation strategy above, an investor may allocate more to cyclical sectors when the economy is showing gains, and more to defensive when it is not.
Academic studies In 1986, Gary P. Brinson, L. Randolph Hood, and SEI's Gilbert L. Beebower (BHB) published a study about asset allocation of 91 large pension funds measured from 1974 to 1983.Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, "Determinants of Portfolio Performance", The Financial Analysts Journal, July/August 1986. They replaced the pension funds' stock, bond, and cash selections with corresponding market indexes. The indexed quarterly return was found to be higher than the pension plan's actual quarterly return. The two quarterly return series' linear correlation was measured at 96.7%, with shared variance of 93.6%. A 1991 follow-up study by Brinson, Singer, and Beebower measured variance of 91.5%.Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, Determinants of Portfolio Performance II: An Update, The Financial Analysts Journal, 47, 3 (1991). The conclusion of the study was that replacing active choices with simple asset classes worked just as well as, if not even better than, professional pension managers. Also, a small number of asset classes was sufficient for financial planning. Financial advisors often pointed to this study to support the idea that asset allocation is more important than all other concerns, which the BHB study is incorrectly thought to have lumped together as "market timing" but was actually policy selection.Meir Statman, "The 93.6% Question of Financial Advisors", The Journal of Investing, Spring 2000, Vol. 9, No. 1: pp. 16–20 One problem with the Brinson study was that the cost factor in the two return series was not clearly discussed. However, in response to a letter to the editor, Hood noted that the returns series were gross of management fees.L. Randolph Hood, "Response to Letter to the Editor", The Financial Analysts Journal 62/1, January/February 2006
In 1997, William Jahnke initiated a debate on this topic, attacking the BHB study in a paper titled "The Asset Allocation Hoax".William Jahnke, "The Asset Allocation Hoax", Journal of Financial Planning, February 1997 The Jahnke discussion appeared in the Journal of Financial Planning as an opinion piece, not a peer reviewed article. Jahnke's main criticism, still undisputed, was that BHB's use of quarterly data dampens the impact of compounding slight portfolio disparities over time, relative to the benchmark. One could compound 2% and 2.15% quarterly over 20 years and see the sizable difference in cumulative return. However, the difference is still 15 basis points (hundredths of a percent) per quarter; the difference is one of perception, not fact.
In 2000, Ibbotson and Kaplan used five asset classes in their study "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?".Roger G. Ibbotson and Paul D. Kaplan, "Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?", The Financial Analysts Journal, January/February 2000 The asset classes included were large-cap US stock, small-cap US stock, non-US stock, US bonds, and cash. Ibbotson and Kaplan examined the 10-year return of 94 US balanced mutual funds versus the corresponding indexed returns. This time, after properly adjusting for the cost of running index funds, the actual returns again failed to beat index returns. The linear correlation between monthly index return series and the actual monthly actual return series was measured at 90.2%, with shared variance of 81.4%. Ibbotson concluded 1) that asset allocation explained 40% of the variation of returns across funds, and 2) that it explained virtually 100% of the level of fund returns. Gary Brinson has expressed his general agreement with the Ibbotson-Kaplan conclusions.
In both studies, it is misleading to make statements such as "asset allocation explains 93.6% of investment return".James Dean Brown, "The coefficient of determination", Shiken: JALT Testing & Evaluation SIG Newsletter, vol. 7, no. 1, March 2003. Even "asset allocation explains 93.6% of quarterly performance variance" leaves much to be desired, because the shared variance could be from pension funds' operating structure. Hood, however, rejects this interpretation on the grounds that pension plans, in particular, cannot cross-share risks and that they are explicitly singular entities, rendering shared variance irrelevant. The statistics were most helpful when used to demonstrate the similarity of the index return series and the actual return series.