While tactical asset allocation calls for discretionary shifts, the remaining three kinds of asset allocation viz, the drifting asset allocation, the balanced asset allocation and the dynamic (or insured) asset allocation involve asset mix changes in accordance with a fixed rule. It may be instructive to compare them.
As discussed earlier, the payoffs associated with the drifting asset allocation policy (or buy and hold policy), the balanced asset allocation policy (or constant mix policy), and the dynamic asset allocation policy (typified by the CPPI policy) are represented by a straight line, a concave curve, and a convex curve respectively. A look at this exhibit suggests that if the stock market moves in only one direction, either up or done, the best policy is the CPPI policy and the worst policy is the balanced asset allocation policy. In between lies the drifting asset allocation.
However, if the stock market reverses itself frequently, rather than moving in the same direction, the balanced asset allocation policy tends to be superior to other policies. To illustrate this point, let us look at the payoff from an initial investment of 100,000 when the market moves from 100 to 80 and back to 100 under the following three policies.
1. A drifting asset allocation policy under which the initial stock bond mix 50:50
2. A balanced asset allocation policy under which the stock bond mix is 50:50
3. A CPPI policy which takes the form:
Investment in stocks = 2 (Portfolio value – 75,000)
The performance features of the three policies are summarized below:
Drifting Asset Allocation Policy>
1. Gives rise to a straight line payoff
2. Provides a definite downside protection
3. Performs between the constant mix policy and the constant proportion portfolio insurance policy.
Balanced Asset Allocation Policy>
1. Give rise to a concave payoff drive
2. Does not provide much downward protection and tends to do relatively poorly in up market.
3. Tends to do very well in flat, but fluctuating markets.
1. Give rise to a convex payoff curve
2. Provides good downside protection and performs well in up market.
3. Tends to do very poorly in flat, but fluctuating markets.
Why Various Policies Coexist:
Tactical asset allocation seems to offer a higher long term reward without corresponding increase in risk. Does it mean that the basic axiom which says, “risk and return go hand in hand” is violated.
The puzzle may be resolved by the utility theory. The connection between risk and return is not inviolate if a higher return strategy provides lower utility than lower return strategy that offers greater comfort. Let us see how this may happen.
As the market advances, investors’ wealth increases but prospective returns diminish; likewise, as the market declines, investors’ wealth decreases but prospective returns improve. Investors broadly display four kinds of responses to these changes:
1. Some investors are unaffected by fluctuations in wealth and their risk tolerance remains the same. They are the true long term investors. When the market advances and prospective stock returns diminish, these investors increase their exposure to bonds. On the other hand when the market declines and prospective returns increase, these investors their exposure to stocks. These investors naturally resort to tactical asset allocation.
2. Other investors are mildly affected by changes in wealth increases, in the wake of a market advance, their risk tolerance too increases, albeit slightly. Similarly a market decline diminishes their risk to tolerance, though slightly. These investors naturally prefer balanced asset allocation.
3. Still another class of investors displays a some what greater sensitivity to recent changes in wealth. As the market rises, their risk tolerance increases and they feel no need to decreases their exposure to stocks, despite diminished prospective returns. Likewise, when the market falls, their risk tolerance diminishes and they feel no need to increases their exposure to stocks. These investors are the natural candidates for the policy of drifting asset allocation.
4. Finally, there is a class of investors which reacts very sharply to recent mar6ket movements. If the market rises, their risk tolerance increases sharply and they want to increase their exposure to stocks, notwithstanding the diminished prospects. If the market falls, their risk tolerance falls sharply and they want to diminish their exposure to stocks. These investors are natural candidates for a policy of dynamic (or insured) asset allocation which says “Buy after a market rise and sell after a market fall”.