What Is Strategic Asset Allocation?
Srategic allocation is based on a long-term outlook.
Strategic asset allocation is a traditional approach to building a portfolio. With strategic asset allocation you determine how much of your money should be invested in broad categories of investments, such as stocks or bonds, and once you have decided upon an allocation you stick with that allocation for many years.
The basis of strategic asset allocation lies in something called Modern Portfolio Theory, which says that markets are efficient, and rather than trying to "bet" on the direction things will go, you should follow a static allocation to take advantage of the efficiency. By using a disciplined strategic approach you can avoid making emotional short-term decisions based on current market events.
How It Works
The allocation process starts with assessing your tolerance for risk and your investing time-frame. Can you reasonably foresee not needing your invested money for an extended period of time? That means you can be more aggressive and allocate more to stocks. Do you remain calm, cool, and collected when the market is jumping up or down? That would also mean that emotionally you would not be disturbed by the high volatility that accompanies a more aggressive allocation.
Once you know how aggressive you can be you determine how much of your money should be in each asset class (such as cash, bonds or stocks) by looking at the long-term expected returns and risk levels of each asset class. Then, each asset class is broken down into additional categories; stocks, for example, would be broken down into large cap, small cap, U.S., international and emerging markets, just to name a few sub-categories. You then develop a strategic asset allocation plan that assigns a target percentage allocation for each underlying category; such as 5% to emerging markets, 10% to U.S. small cap, etc.
You can follow a strategic asset allocation approach by using a balanced mutual fund which chooses and monitors the allocation for you. Many 401(k) plans also offer "model" portfolio allocations which do the work for you.
What Does Strategic Asset Allocation Look Like?
A strategic asset allocation recommendation might suggest that you have 70% stocks/20% bonds/10% cash, or 60% stocks/40% bonds. You might see such an allocation referred to as a “70/20/10” portfolio or a “60/40” portfolio. You can use an online risk questionnaire and calculator to see a sample of a strategic asset allocation plan based on your answers to the risk questions.
Once your strategic asset allocation is determined, the portfolio is typically re-balanced on a pre-determined basis, annually for example, back to its original allocation.
For example, let's assume you have an allocation model which targets a stock allocation of 60% and a bond allocation of 40%. Stocks have been great, and now 70% of your portfolio is composed of stocks. Strategic asset allocation says to take profits by selling the excess 10% in stocks in order to bring your stock allocation back down to 60%. You will now reinvest the money into bonds. Some investment sub-categories will always do well while others are not doing so well. Rebalancing forces you to take profits from categories that have done well.
The strategic asset allocation approach involves sticking with your original allocation over long periods of time rather than reacting to what is currently occurring in the markets.
One thing to think about: you may have the same risk tolerance your whole life - meaning your comfort level with volatile markets may be just fine. However, as the time to withdraw funds in retirement comes near, you may want to have less exposure to risk.
Strategic vs. Tactical
Strategic asset allocation is different than tactical allocation which focuses on the timing of how you move money in and out of investment categories. Tactical asset allocation approaches involve moving funds around more frequently. The tactical approach takes more expertise, and, of course, there are no guarantees it will deliver better results.