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"The most important key to successful investing can be summed up in just two words: asset allocation."
Michael LeBoeuf
In developing portfolios tailored to our clients’ individual needs and financial goals, RP Wealth Advisors utilizes a blended model consisting of strategic, tactical, and dynamic asset allocation. Each facet of a portfolio constructed in this way provides different benefits and allows for customization based on individual risk tolerance, investing horizons, and goals.
Also, diversification across different, non-correlated asset classes helps to “smooth” out market fluctuations to establish a more formidable barrier in protecting wealth, and a more flexible approach in growing wealth based on market conditions. In our approach to long-term wealth-building and management, we seek "the smoothest air to reach the destination."
What is Asset Allocation?
Although “personal assets” generally include property, collectibles, investments, land, cash and cash equivalents, among others, the focus of this post is on portfolio investments. Essentially, asset allocation within your investment portfolio is a strategy to balance risk and reward by apportioning assets in accord with your risk tolerance, investment timeline, and goals. The three main asset classes that make up portfolio investments include equities (“stocks”), fixed-income (“bonds”), and cash and equivalents.
Each asset class has different levels of risk and return, and will behave differently over time and through different economic cycles – the percent allocation of each class in your portfolio will shape the magnitude of both your returns and drawdowns.
Why Asset Allocation Matters
There is no “one size fits all” approach to asset allocation – individual risk tolerance, time horizon, goals, personality, values, etc. each factor in to crafting an appropriate investment portfolio.
Weighing each factor is essential because asset allocation is one of the most significant decisions any investor makes. Generally, the way in which assets are appropriated in a portfolio is more determinant in the portfolio’s results than the selection of individual securities. In fact, “extensive research has shown that, if you have a diversified portfolio, a whopping 88% of your experience (the volatility you encounter and the returns you earn) can be traced back to your asset allocation.”1
Asset allocation helps reduce risk through diversification. For the most part, the returns of stocks, bonds, and cash do not move in tandem. Market conditions which cause one asset class to outperform others during a specific timeframe may cause others to underperform. The result is less volatility for investors on a portfolio level since these movements offset one another. Some recent studies have shown, however, correlation increases during the largest market drawdowns. Thus, the implementation of tactical management, and dynamic management to offset strategic, is of even greater importance.
Our Approach to Building Your Portfolio
Through our meetings and discussions with clients, RP Wealth Advisors synthesizes risk tolerance, time horizon, goals, and other factors in an effort to create portfolio solutions tailored to each client’s needs. In working with different investment and portfolio managers, Chartered Financial Analysts (CFAs), and strategists, we seek better risk-adjusted returns via a combination of strategic, dynamic, and tactical asset allocation models.
Well-planned asset allocation is instrumental in striving toward your financial goals. An investor who is not taking sufficient risk may not generate high enough returns to reach a specific goal. Conversely, an investor taking on excessive risk may not have enough money when they need to access it. Selecting the appropriate asset allocation may help avoid these issues by positioning a portfolio to reach a given goal.
The Basics of Strategic Asset Allocation
Like all forms of portfolio building and management, the target allocations depend on factors such as risk tolerance, time horizon, and investment objectives. Allocations may change over time as the parameters change. Strategic asset allocation involves setting targets for each asset class, and then rebalancing periodically. This keeps the weights for each class in check over the long run.
Strategic asset allocation also involves, to some extent, contrarian investing. In order to maintain the pre-determined weights for each class, top-performing positions will be sold (to bring their weight in the portfolio down) and proceeds will be used to “top up” underperforming positions (bringing their weight in the portfolio up). This rebalancing, when investments are made in an advisory account, is often done automatically.
Strategic asset allocation is similar to “buy-and-hold” investing, which contrasts with tactical asset allocation – more on that below. Both strategic and tactical asset allocation styles are based on Modern Portfolio Theory (MPT), developed by Harry Markowitz, which emphasizes diversification to reduce risk and improve portfolio returns.
The Basics of Tactical Asset Allocation
Over the long run, strategic asset allocation may seem relatively robotic. This is balanced out by incorporating short-term, tactical deviations to take advantage of unique investment opportunities (say, a global pandemic, for example…). This flexibility adds a market-timing flavor to a portfolio, allowing our clients to participate in economic conditions more favorable for one asset class than for others.
Tactical asset allocation is a moderately active approach within an investment portfolio. The overall strategic asset mix is returned to when desired short-term profits are achieved. This strategy necessitates discipline, as money managers must be able to recognize when short-term opportunities have run their course and then rebalance the portfolio to the long-term asset position. Tactical managers, within a portfolio, may also periodically “go to cash” (as a defensive maneuver) in an effort to preserve capital when downturns are expected.
The Basics of Dynamic Asset Allocation
Another active asset allocation strategy is dynamic asset allocation. Within this strategy, managers constantly adjust the mix of assets as markets rise and fall, and as the economy strengthens and weakens. With this strategy, assets that decline are sold and assets that increase are purchased. For example, when the stock market shows weakness, managers sell select equity positions in anticipation of further decreases. But, if the market is strong, managers purchase equities in anticipation of continued market gains.
The general goal of dynamic asset allocation is to react to current risks and downturns and take advantage of trends to realize returns that exceed predetermined benchmarks, such as the Standard & Poor’s 500 index (S&P 500) or a global equities index like the MSCI World Index.
Dynamic asset allocation relies on a portfolio manager's judgment instead of a target mix of assets. There is typically no target asset mix, as investment managers can adjust portfolio allocations as they see fit. The success of dynamic asset allocation depends on the portfolio manager making good investment decisions at the right time.
Bringing It All Together: Your Goals & Your Portfolio
By coordinating with different managers who take a strategic, tactical, and dynamic approach, RP Wealth Advisors seeks to synthesize clients’ investing preferences and needs with the asset allocations within each investor's portfolio.
Utilizing different managers within a given portfolio allows for customization and tilts that look favorable over the next one to three years. Generally, repositioning and rebalancing is done with a medium to long-term investment horizon with the goal of being in the right place when the market moves in any given direction. As Wayne Gretzky once said, “I skate to where the puck is going, not to where it has been.”
In addition to considerations such as tax efficiency, liquidity needs, income requirements, etc., these asset allocation strategies allow for customization, diversification, and results geared toward both clients’ needs and goals.
1. Source: Vanguard, The Global Case for Strategic Asset Allocation (Wallick et al., 2012).
Diversification and asset allocation are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss. All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful. The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by RP Wealth Advisors to provide information on a topic that may be of interest. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.