A basic decision that every investor needs to make is how to distribute one’s investable funds across various asset classes.
A basic decision that every investor needs to make is how to distribute one’s investable funds across various asset classes. An asset class is a category of assets that have similar characteristics and risk-return relationships.
Asset classes vary from equity, fixed-income instruments and cash equivalents to alternative assets and real estate, and so on.
Asset allocation is surely not easy as there are many sub-asset classes within each asset class. For example, consider the equity asset class, within which we have domestic equity, global depository receipts, large caps, mid caps, small caps, value stocks, growth stocks, and so on.
Fixed-income instruments can further be classified into government and corporate bonds, investment grade bonds, high-yield bonds, etc. Cash equivalent could be bank fixed deposits, treasury bills, etc. Alternative assets ranges from private equity to hedge funds. Real estate could be residential or commercial. Collectibles range from art to antique.
Let’s discuss some of the strategies in the asset allocation process.
Strategic asset allocation
Strategic asset allocation is driven by long-term risk-return expectations from various asset classes. One of the key reasons why strategic asset allocations don’t often change is that long-term risk-return expectations don’t change often either. Although markets tend to be volatile and returns often diverge sharply from year to year, yet viewed over the longer term, they tend to become more stable, with gains in some years offsetting losses in others.
This suggests that risk-return assumptions that form the basis of strategic asset allocation should be periodically evaluated and modified when the investment landscape changes materially, e.g., a shift in longer-term growth rates, a change in inflation expectations or a shift in risk premiums. A robust process of estimating long-term risk-return expectations should, therefore, not be unduly impacted by near-term activity. In fact, frequent changes to long-term risk-return expectations could seriously undermine investment discipline.
Tactical asset allocation
Whereas the key drivers of strategic asset allocation are long-term risk and return expectations from various asset classes, tactical asset allocation focuses on drivers like valuation, momentum, sentiment, business cycle and fiscal and monetary factors. These factors help identify asset classes that are expected to outperform or underperform in the near term.
Temporary overweighting or underweighting of components of strategic asset allocation can help enhance performance over time. This includes not only overweighting those asset classes or sectors that may provide better near-term return prospects, but also underweighting those that appear overvalued or are vulnerable to near-term event risk.
These tactical allocation decisions vary with much greater frequency than changes in the strategic asset allocation weightings. However, even tactical rebalancing must be done in a disciplined manner, with due consideration to benefits, risks and costs associated.
Which one to follow
While strategic and tactical asset allocation may differ in terms of time horizon and key drivers, they must be viewed as complementary.
Strategic asset allocation provides the anchor to help ensure that long-term investment objectives are met, while the tactical range determines the magnitude of acceptable tactical changes.
The writer is associate professor of finance and accounting, IIM Shillong