Strategic Asset Allocation or the Art of Diversification
The cornerstone of a successful long-term portfolio management
Why is Strategic Asset Allocation an important step in portfolio management? How to combine asset classes: shares, bonds, real estate, private equity, commodities, etc. in the most efficient way?
“More than 75% of the variability of returns associated with a portfolio is determined by STRATEGIC ASSET ALLOCATION”
Hoernemann, Junkans & Zarate Study, 2005
What is strategic asset allocation?
Strategic Asset Allocation is definitely the first important step when building your portfolio allocation. In a context of market volatility, it is not sufficient to buy and hold stocks or bonds in an opportunistic manner to weather market shocks. So, first of all, before thinking of investing in single products, investors should step back, think long term (5 to 10 years) and define and build, at the asset class level, the most appropriate portfolio allocation, according to their risk and return profile. This structured approach, based on diversification, that aims to maximize performance at constant risk, is called "strategic asset allocation" and provides an efficient framework to preserve capital over the long term.
What is strategic asset allocation as opposed to tactical asset allocation?
With Strategic Asset Allocation, you aim at building the robust foundations of your portfolio management strategy, with a long-term investment horizon (5 to 10 years), while deciding the right balance between asset classes. On the other hand, with Tactical Asset Allocation (the following step) you aim at taking advantage of short-term market opportunities (market pricing anomalies, strong market sectors, etc.), by selecting the most relevant investment products by asset class and choosing the best market timing. Tactical allocation therefore adjusts the asset allocation in an active and flexible way, unlike strategic allocation, which defines a target allocation over the long term. Both approaches are complementary and will make your portfolio management successful.
What are the benefits of strategic asset allocation?
Efficient strategic asset allocation is an important source of portfolio performance stabilization in the long run: according to a reference research, more than 75% of the variability of a portfolio's returns can be explained by strategic asset allocation. Indeed building the right asset mix from the outset, in line with your personal objectives, is definitely an important step to help you preserve your wealth. If you skip that step, you may end up making the wrong bets on only a few ideas, often based on a risky investment strategy (except if you are the new Warren Buffett, and if so I wish you the very best!) and could be potentially caught in a buy-and-sell spiral. Conversely, strategic asset allocation allows decisions to be made on the basis of clear objectives, without overreacting to market fluctuations.
How to determine a strategic asset allocation?
To perform strategic asset allocation, you need to ask yourself right at the beginning several key questions: What is my performance target? What level of loss can I bear? What are my liquidity needs? Do I have a specific timeframe (e.g. retirement) or a project (a property investment, the sale of my private company, etc.)? Then, based on these goals and needs, the next step is to determine the right asset class mix. Strategic asset allocation relies on efficient diversification, leveraging on 3 key parameters about asset classes: their specific risk-return profile, their sensitivity to economic factors (growth and inflation), and the intensity of connections (i.e. correlations) between them to combine them in the most efficient way.
What is a typical strategic asset allocation?
There is no typical strategic asset allocation because it depends on the investor's risk-return profile, which can vary substantially from one person to the next! For example, if you are about to retire, and have been investing for 30 years, your main concern may be to clarify and optimize your portfolio allocation to pass it on to your children in a smooth way. Your “ideal” allocation may be completely different from that of a young entrepreneur who has just sold his/her company and is planning to set up another business and/or embark on a major real estate project. That said, a typical strategic asset allocation for a rather balanced investor could be: 40% cash & bonds, 30% shares, 15% real estate and 15% alternative investments (private equity, commodities and hedge funds).