What Is Strategic Asset Allocation?
Find out whether this long-term allocation strategy is right for you
One of the most important financial decisions you will make is how you will allocate the assets in your retirement portfolio—that is, what investment classes you will choose and what percentage of each you want to hold in your portfolio. One way to achieve an effective portfolio is to employ a strategic asset allocation, a static allocation approach that trusts in the market over individual impulses. By understanding and using this disciplined approach, you can avoid making emotional short-term decisions based on current market events.
Basics of Strategic Asset Allocation
This traditional approach is based on Modern Portfolio Theory, which posits that markets are efficient. Rather than trying to "bet" on financial trends, you should establish a fixed allocation to take advantage of the built-in efficiency of the market.
The strategy requires you to determine how much of your money should be invested in broad categories of investments, such as stocks or bonds, along with investment sub-categories, such as U.S. small-cap and mid-cap stocks. Once you have decided upon an allocation, you stick with that allocation for many years.
Choosing a Strategic vs. Tactical Allocation
Strategic asset allocation takes a more passive approach to investing, whereas tactical allocation involves more actively managing a portfolio. The best asset allocation strategy for you depends on your investing style.
Strategic asset allocation is more appropriate if:
- You prefer a hands-off approach: With this investment allocation approach, you purchase investments in a certain mix and only rebalance them (buy some and sell others) when the allocation diverges from that mix. This is an ideal strategy for those who don't want to touch or think about their investments often.
- You want to buy and hold: You'll purchase investments and keep them over the long term. This means you seldom have to move money around or incur the associated transaction fees.
- You have a long time horizon: The longer you have until you need the money in your portfolio, the more appealing a strategic asset allocation is since there is still plenty of time for the market to recover from potential downturns. This makes a strategic asset allocation perfect for retirement savers.
- You have limited investing experience: This asset allocation strategy requires research at the time you pick investments but doesn't demand deep insights into market trends because they generally shouldn't move you to change your picks. You may want to choose this approach if you don't have the experience needed to act on ongoing market events.
- You're an emotional investor: Some people choose this investment allocation strategy to curb their own impulses to drop an investment at the first sign of a market downturn. A strategic asset allocation forces you to adhere to your original asset allocation no matter what the market brings.
The tactical approach is appropriate if:
- You want greater control: If you don't necessarily trust in the market to steer your investments in the right direction, this asset allocation strategy may be a better option.
- You're willing to trade often: The opposite of a buy-and-hold strategy is a trading approach where you don't simply stick to your original investment choices over a period of years, but rather monitor them on an ongoing basis and act on investment opportunities as they arise. This may result in moving around money frequently, which can incur higher transaction fees.
- You have a short- to medium-term time horizon: A tactical approach may be more suited for money in a regular investment account that you're looking to grow but for no defined long-term goal.
- You have more expertise: If you have a lot of insight into the market and how to prudently act on changes, this option may appeal to you. But there are no guarantees you will get better results than with a strategic asset allocation.
Achieving a Strategic Asset Allocation
Follow these steps to assemble a portfolio that suits your investor profile.
Determine your tolerance for risk. This is the amount of volatility you are willing to tolerate. If you can remain calm when the market is falling, you can be more aggressive by putting more money into stocks. If you tend to get jumpy during a downturn, you may want to invest more conservatively through more bonds or cash.
Consider your time horizon. How long do you plan to hold investments? What you plan to do with the proceeds will affect your time horizon. If you don't anticipate needing your invested money for an extended period of time, you can be more aggressive. In general, the longer your time horizon, the less disturbed you should be by the high volatility that accompanies a more aggressive allocation.
Factor in your investment objectives. Is your goal to achieve capital growth, fixed income, or a mix of the two? Growth generally requires a more aggressive investment allocation, while income calls for a more conservative approach.
Determine what percentage of your invested money should be in each asset class. Asset classes include cash, bonds, or stocks. Look at the long-term expected returns and risk levels of each asset class when deciding on the target percentage for each class. Stocks are the riskiest; bonds are less risky, and cash is the least risky.
Break down each asset class into additional categories. Stocks, for example, can be broken down into large-cap, small-cap, U.S., international, and emerging markets, to name a few sub-categories.
Develop a strategic asset allocation plan. Assign a target percentage allocation for each underlying category—for example, 10% to U.S. small-cap stocks.
Purchase funds according to the allocation plan. You can buy multiple individual funds that cumulatively achieve the desired allocation. Or, you can buy a balanced mutual fund, which includes stocks and bonds in a single fund, usually at fixed percentages (for example, 60% stock/40% bonds). Many 401(k) plans also offer "model" portfolio allocations that do the work for you.
Example of Strategic Asset Allocation
If you're not sure what mix of investments to choose, and in what percentage, 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.
For example, an 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.
In general, the greater your risk tolerance, the more aggressive you can be and the more you should put into stock if your investment objective is to maximize long-term growth. For a visual example. take a look at the chart below, which illustrates hypothetical strategic asset allocations based on various levels of risk.
Once you determine your asset allocation strategy, re-balance it on a pre-determined basis (annually, for example) to restore the original allocation. For example, let's assume you developed an asset allocation that targets 60% stock and 40% bonds. Currently, 70% of your portfolio consists of stocks. Under a strategic asset allocation approach, even if stocks are performing well at present, you should sell the excess 10% in stocks in order to bring your stock allocation back down to the target percentage of 60%. You should then reinvest the proceeds into bonds.
Over your planned investment horizon, some investment sub-categories will do well, while others will not do so well. Rebalancing forces you to move money from classes that have done well regardless. This is because 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.
If you obtain information that warrants a change in the allocation itself, it's acceptable to change it and then stick to it. Remember: A strategic asset allocation is an approach for keeping you on track with your investment goals regardless of market whims; it's not a life sentence.
The Bottom Line
The strategic asset allocation is an ideal choice for the typical buy-and-hold investor who may not have extensive investing experience but wants a hands-off approach to saving for the long-term goal of retirement. Investors who prefer to actively manage their investments over a shorter period of time can also consider a tactical asset allocation strategy.
One thing to think about: You may have the same risk tolerance your whole life, meaning that your comfort with volatile markets now may not change as you age. Even so, as the time approaches to withdraw funds from a retirement account, you may want to reduce your exposure to risk because you may not be able to generate the income in retirement needed to replace investment losses during a downturn.
For this reason, investors usually transition to a more conservative investment allocation strategy as they near retirement incorporating less stock and more bonds. Consult with a financial adviser for advice on how to accomplish this in a way that still meets your investing goals. You may choose not to implement an advisor's recommendations, but at least you will have evaluated all your options.