As an investor, a primary goal is to manage the risk in the investment portfolio, and this is typically accomplished by allocating capital across different asset classes. Which asset allocation is appropriate is dependent upon the time horizon, risk tolerance, and investment objectives of the investor as well as other external factors.
Strategic asset allocation versus tactical asset allocation
At the most basic level, asset allocation models are oftentimes classified as “strategic” or “tactical”. A strategic asset allocation is based upon the time horizon, risk tolerance and investment objectives of the investor, while a tactical allocation takes into account market conditions, economic and political factors, security analysis, and other factors external to the situation and needs of the individual investor.
Strategic asset allocation
The strategic allocation will depend on factors unique to the investor. For example, for a risk averse individual with a short time horizon the ideal strategic asset allocation will likely consist of a large amount of bonds and cash and a small amount of stocks, whereas for an aggressive investor with a long time horizon the ideal strategic asset allocation will likely consist of a large amount of stocks and a small amount of bonds. When constructing a strategic allocation, a common rule of thumb is to base the bond allocation in the portfolio on the investor’s age.
For example, a 30 year old investor using this method would allocate 30% of the portfolio to bonds and cash and the remaining 70% to stocks, whereas a 65 year old investor would allocate 65% of the portfolio to bonds and cash and the remaining 35% to stocks. Of course, this is only a rule of thumb should be used in conjunction with the time horizon and risk tolerance of the investor as well as other factors related to the financial situation of the investor. We emphasize the importance of consulting with the appropriate advisers in implementing an asset allocation and a corresponding investment program.
Tactical asset allocation
Tactical asset allocation involves taking into account factors external to the needs and attributes of the investor. Factors include economic, political, and market conditions. For example, if the investor and/or investment manager believe that a recession is imminent, they may consider reducing exposure to equities and making a corresponding increase in the exposure to bonds and cash. Another example involves factors related to the financial position of the individual company or companies in question, and the capital structure represented by the corresponding securities which are involved. In this scenario, the investor may consider increasing exposure to those securities which are believed to be undervalued and decreasing exposure to those securities believed to be overvalued.