Bobby Moyer, CFA, CFP®, CAIA Chief Investment Officer
An investor’s strategic asset allocation is an investment portfolio’s target mix of different asset categories. Generally, a strategic asset allocation will be rebalanced, commonly annually, to ensure the current investment allocation is not significantly over or underweight a certain asset category. If an asset allocation deviates too much from a target allocation the investor may not be taking the appropriate risk for their given objective.
A strategic asset allocation is determined by two general factors: Time Horizon and Risk Tolerance. An investor’s time horizon outlines when the funds may be needed. If money is not expected to be needed for many years, a longer time horizon is assumed, which is a characteristic of a more aggressive (more stocks relative to bonds) strategic allocation. Risk tolerance defines an investor’s tolerance for taking risk. Some investors are more risk averse than others, and even small amounts of risk cause great anxiety and loss of sleep for some, while others feel very comfortable taking risk. A strategic asset allocation is determined by considering the investor’s time horizon and risk tolerance. However, it is common for an investor to have multiple goals with different time horizons. Because of this, it may be appropriate for an investor to have two separate accounts and two different strategic asset allocations. An example would be an investor in their forties who has an aggressive strategic asset allocation for their retirement funds but a more conservative strategic asset allocation for their emergency fund or an account to buy a new car in two years.
Two Reasons Most Investors Should Have a Strategic Asset Allocation
- Avoid Having to Time the Market
Market timing can be one of the biggest detractors from the long-term performance of an investment portfolio. When markets get volatile it could be tempting to want to move your investments to cash or become more conservative to avoid any additional emotional distress of seeing your account fall any lower. Unfortunately, the decision to abort your current strategy may occur at the wrong time. Your decision may be triggered by substantial drops, and if you sell stocks at losses near their bottom, you may miss the rapid recoveries that often follow large declines, like we witnessed in March of 2009. Investors make mistakes timing the markets when times are good, too. A common mistake is when an investor waits for months or years for the next drop as a good buying opportunity. This sounds smart in theory, but in practice often leads to missing out on long periods of strong returns.
In hindsight, your vision of timing the market is always 20/20, but the truth is that it is very difficult to time the market even once, let alone on a consistent basis. Additionally, for every attempt to time the market, you need to be correct twice, when to sell and when to repurchase.
By having a strategic asset allocation, you determine your appropriate risk profile and you stick with it.
- Give Your Investments a Purpose
Some investors use an ad hoc approach to investing—they buy stocks they like or maybe they act on advice they got from a friend at a cocktail party. They probably have no idea how they are allocated, how risky their portfolio is or know how their portfolio should behave during a certain type of market. Determining a strategic asset allocation forces you to have a plan and to think about the purpose of your investment portfolio. By having a plan you have a better chance of reaching your goals.
So who does not need a strategic asset allocation?
Somebody with significantly more money than they need. If you have a few billion dollars, you don’t need to invest at all, or you can invest in all equities or all bonds, it probably won’t matter, unless you were to invest in one speculative stock that goes bankrupt. Maybe some of those lottery winners that won tens to hundreds of millions of dollars and ended up bankrupt a few years later would still be millionaires if they had a strategic asset allocation.
If you found this blog informative or want to learn more, read our blog Asset Allocation Strategies for Retirement Planning.
