The term asset allocation means different things to different people in different contexts. We will look at the following versions of asset allocation:
1. Strategic asset allocation
2. Tactical asset allocation
3. Drifting asset allocation
4. Balanced asset allocation
5. Dynamic (insured) asset allocation
While strategic asset allocation is concerned with establishing the long term asset mix of a portfolio, the other types of asset allocation refer to what portfolio manager does in response to evolving market conditions.
Strategic Asset Allocation:
The strategic asset allocation refers to the long term ‘normal’ asset mix sought by the investor (or portfolio manager) to achieve an ideal blend of risk and return. It may be established with the help of either an informal or a formal approach.
Informal Approach: The informal approach to strategic asset allocation essentially involves three broad steps:
1. Subjectively assess the risk tolerance as low medium or high.
2. Define the investment horizon as short intermediate or long.
3. Establish the optimal strategic asset allocations using some rule of thumb.
Formal Approach: The formal approach to strategic asset allocation involves the following steps:
1. Develop quantitative forecasts of expected returns, standard deviations, and correlations of the two asset categories, viz., stocks and bonds.
2. Define the efficient frontier which contains all the efficient portfolio options available to the investor. Remember that a portfolio is efficient if (and only if) there is no alternative with (1) the same E (Rp), and a lower (S)p (2) the same (S)p and a higher E(Rp), or (3) a higher E(Rp) and a lower (S)p. Figure shows the efficient frontier which represents the best possible combinations of stocks and bonds.
3. Specify the utility indifference curves reflecting the risk disposition of the investor. Illustrative utility indifferences curves are shown in figure. Note that all points lying on a utility indifference curve provide the same level of satisfaction. For example, points X and Y which lie on the utility indifference curve I1 offer the same level of satisfaction. The level of satisfaction increases as one moves leftward. The utility indifferences curve I2 offers a higher level of satisfaction as compared to the utility indifferences curve I1 and so on.
4. Choose the optimal portfolio (asset allocation). The optimal portfolio is found at the point of tangency between the efficient frontier and a utility indifference curve. This point represents the highest level of utility the investor can reach. Figure shows that the optimal portfolio (strategic asset allocation) for the investor is represented by point O.
Tactical Asset Allocation:
Tactical asset allocation involves a conscious departure from the strategic or normal asset mix based on rigorous and objective measurement of value. The objective of tactical asset allocation is to enhance the performance of the portfolio through an opportunistic shift in the asset mix in response to changing patterns of reward in the capital market. The distinctive features of tactical asset allocation are as follows:
1. It is guided by objective measures of prospective values like earnings yield and yield to maturity. Hence it is essentially a value oriented approach.
2. It is inherently contrarian in nature as it involves buying after a market decline and selling after a market rise.
Note that tactical asset allocation entails market timing. The only difference between the traditional market timing and tactical asset allocation (a modern version for market timing) is that the latter is supposed to be analytically disciplined and based on objective measures of value.
Drifting Asset Allocation:
This policy advocates that the initial portfolio be left undisturbed. It is essentially a buy and hold policy. Irrespective of what happens to relative values, no rebalancing is done.
1. The value of portfolio is linearly related to that of the stock market.
2. While the portfolio value cannot fall below the value of the initial investment in bonds, its upside potential is unlimited.
3. When stocks outperform bonds, the higher the initial percentage in stocks, the better the performance of the buy-and-hold policy. On the other hand, when stocks under perform bonds, the higher the initial percentage in stocks, the worse the performance of the buy-and-hold policy.