Most investors struggle with an asset allocation model that will optimize their risk and returns. Most, without even realizing it, implement a strategic asset allocation because it is the most often taught model by mainstream financial planners and the media. However, today there is a growing debate that is challenging this investment model.
What is a Strategic Asset Allocation?
Strategic asset allocation describes a model in which the portfolio mix of assets is fixed according to the individual investor’s profile. The percentage of assets allocated to cash, bonds, stocks, real estate, etc. is set according to the investor’s goals and strategies, current financial status, and risk tolerance.
The key supposition is the asset allocation remains fixed unless the investor’s profile changes. In other words, if the investor determines that 60% equities, 30% bonds, and 10% cash is their target asset allocation, then that will be the target unless there is a change in the investor’s goals and strategies, current financial status, or risk tolerance.
Advantages of a Strategic Asset Allocation Model
There are two main advantages of a Strategic Asset Allocation:
1. Relatively easy to maintain.
2. Tailored to the individual investor’s profile.
With a strategic asset allocation the investor can invest on “auto pilot”. After the initial analysis that determines the investor’s goals and strategies, financial status, and risk tolerance, little effort is needed to maintain the set asset allocation.
Disadvantages of a Strategic Asset Allocation Model
This main disadvantage of a strategic asset allocation model is that it only considers the investor’s profile. The other half of the equation is the non-investor factors. The most important non-investor factor is the valuation of the opportunities available. This important factor is completely ignored by a strategic asset allocation model.
Would a Tactical Asset Allocation Strategy be Better?
I believe a tactical asset allocation strategy is best because it can adapt to both the investor’s profile and non-investor considerations such as valuations and intrinsic value . The irony of using this strategy is that it lowers risks and actually makes investor profile considerations less important. Regardless of investor’s profile; does it make sense for anyone to invest when the odds are poor?
We know from history that when you buy investment assets at high prices compared to their intrinsic value you will make below average rates of return in the long run. Conversely, when you buy investment assets that have low or reasonable values compared to their intrinsic value you can achieve higher than average rates of return in the long run.
Think about it, did it make sense to have the same allocation to equities in 2000 as it did in say March of 2009? A strategic asset allocation would have had the same percentage allocated to equities when they were selling at historically expensive prices compared to earnings as when they were selling at a fraction of those prices a few years later.
Do you think valuation should be considered in your portfolio asset allocation?