What is strategic asset allocation?
Strategic asset allocation is a long-term strategy whereby you decide how to divide your investment portfolio among different asset classes — mainly stocks, bonds, and cash — based on your risk tolerance, time horizon, and financial goals.
You start by setting the target weights or proportions for each asset class.
After that, you periodically adjust the current portfolio allocations to rebalance them back to the original targets. These weights will tend to deviate from your targets over time, due to the assets’ differing performance. The rebalancing is usually done at regular intervals, such as annually.
The aim is to balance risks and returns through a diversified investment portfolio in the long run, to attain your financial goals.
How strategic investing works
Here’s an example to illustrate how strategic asset allocation works.
Jane is 30 years old and has a moderate risk tolerance. A year ago, she invested $200,000, split into 50% equities, 30% bonds, 15% commodities, and 5% cash. That worked out to target allocations of $100,000 for stocks, $60,000 for bonds, $30,000 for commodities, and $10,000 for cash.
The table below shows her target allocations as well as the assets’ current market values a year after she made these investments, based on their respective annual returns.
Her portfolio value has grown to $215,050 after one year. It is now made up of 52.1% equities, 28.6% bonds, 14.6% commodities, and 4.7% cash. These weights deviate from Jane’s target proportions.
Under the strategic asset allocation approach, she therefore readjusts the investments in each category back to the original targets, as shown in the following table. For instance, to make sure equities make up half of the latest $215,050 portfolio, she sells $4,475 worth of shares. Using those sales proceeds, she buys more bonds and commodities while putting more cash into the portfolio.
After the rebalancing, her portfolio is back to 50% equities, 30% bonds, 15% commodities, and 5% cash.
This is considered a passive investment strategy, as it does not require frequent changes to the portfolio in response to short-term market fluctuations. Learn more about Endowus' Strategic Passive Asset Allocation here.
What is tactical allocation?
In contrast, the tactical asset allocation strategy is an active investing approach. It involves more frequent trading and a shorter-term view.
Tactical investors modify their portfolio’s allocations based on the latest market conditions, which may change often. The goal is to maximise short-term profits and portfolio returns.
By actively shifting the proportions of their investments, they hope to take advantage of prevailing or expected market trends, economic conditions, or perceived mispricing opportunities.
Staying with the earlier example, let’s say that after the first year of her investment journey, Jane believes she now has enough expertise, interest, and time for tactical asset allocation, and stops using the strategic approach.
She expects a recession to happen soon, considering the current macroeconomic situation and growing inflationary pressures. As a tactical investor, she decides to shift away from equities and into lower-risk and potentially inflation-hedging assets such as bonds and commodities. She keeps the cash allocation at 5%.
When Jane rebalances her $215,050 portfolio, she cuts the weighting of equities to 40%, from 50% previously. The proportion of bonds is increased to 35%, from her original target of 30%. And she allocates 20% to commodities, up from 5% under the strategic approach.
If she sticks with tactical asset allocation, Jane will likely adjust her portfolio again when the global economy recovers. This may involve buying more shares so she can become more aggressive with regards to equities.
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