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Role of Asset Allocation

in Portfolio Management

FINANCE 2015-17

What is Asset Allocation ?

It is an investing portfolio technique that aims to balance risk and

create diversification by dividing assets among major categories such
as cash, bonds, stocks, real estate, derivatives, etc.

Each asset class has different level of risk and return, so each will
behave differently over time

The selection of stocks or bonds is secondary to the way we allocate

our assets to high and low risk stocks, to short and long term bonds and
to cash on the sidelines

There isnt any simple formula to find the right asset allocation for
every individual

Risk Vs. Return

The risk vs. return tradeoff is at the core of what asset allocation is all

Wanting highest possible return by choosing the assets with the highest
potential is not the answer, case of 2009 can be seen, where investing
in stocks of high potential was not the prudent plan of action

What separates greedy and return hungry investors from the successful
ones is the ability to weigh the difference between risk and return

Risk appetite varies from investor to investor, hence the allocation of

investment will vary, like investors with high risk tolerance should
allocate more money into stocks

Not relying on Financial Software

Financial Software and Survey sheets designed by financial advisors

and investment banks can be beneficial but should never be relied on
solely. For example: As per an old thumb rule of advisors, they used to
determine the proportion a person should allocate to stocks is to
subtract the persons age from 100

The financial software dont take into account other important

information such as whether or not the person is a parent, retiree or

These financial software and planner sheets should only be used to take
a rough idea

Asset Allocation Strategies


Strategic Asset Allocation

This method adheres to base policy mix a proportional combination

of assets based on expected rates of return for each asset class is done.
For example:
If stocks have historically returned 10% per year and bonds have
returned 5% per year, a mix of 50% stocks and 50% bonds will be
expected to give a return 7.5% per year

2. Constant- Weighing Asset Allocation

In this approach, we continually rebalance our portfolio For example: If

one asset is declining in value, we would purchase more of that asset,
and if that asset value is increasing, we would sell it

A common thumb rule is that the portfolio should be rebalanced to its

original mix when any asset class moves more than 5% of its original

3. Tactical Asset Allocation

It can be described as a moderately active strategy, since the overall

strategic asset mix is returned to when desired short term short term
profits are achieved

This strategy should be in a disciplined way, as we must be able to

recognize when short term opportunities have run their course, and
then balance the portfolio for the long term asset position

4. Insured Asset Allocation

We establish a base portfolio under which the portfolio should not be

allowed to drop. As long as the portfolio achieves a return above its
base, we exercise active management to try to increase the portfolio
value as much as possible.
If the portfolio drops down to the base value, we invest in risk free
assets so that the base value becomes fixed

5. Dynamic Asset Allocation

Just the opposite of Constant-Weighing strategy, within which we

constantly adjust the mix of assets as markets rise and fall and as the
economy strengthens or weakens.
As per this strategy, we sell assets that are declining and purchase
assets that are increasing.
We anticipate that if stock market is showing weakness then it will
weaken further, and similarly if the stock market strengthens.