What is asset allocation?

Asset allocation is the process of deciding how to distribute an investor’s wealth among asset classes for investment purposes.

Asset allocation is a term used to describe how an investor chooses to divvy up his or her investments among the different asset classes.

An asset class is comprised of securities that have similar characteristics, attributes, and risk/return relationships.

A broad asset class, such as “bonds,” can be divided into smaller asset classes, such as Treasury bonds, corporate bonds, and high-yield bonds.


Example of Asset Allocation

Let’s examine a sample portfolio for a fictional investor, Mr. John Smith:

Small-Cap Growth Stocks — 25%

Large-Cap Value Stocks — 25%

International Stocks — 10%

Intermediate Government Bonds — 15%

High-Yield Bonds — 15%

Cash/Money Market — 10%

The overall portfolio has a 60/40 mix of stocks and bonds.


The Portfolio Management Process

The portfolio management process is the process an investor takes to aid him in meeting his investment goals.


Steps of Portfolio Management Process

There are four-step of the portfolio management process.

(1) Create a Policy Statement –A policy statement is a statement that contains the investor’s goals and constraints as it relates to his investments.

(2) Develop an Investment Strategy – This entails creating a strategy that combines the investor’s goals and objectives with the current financial market and economic conditions.

(3) Implement the Plan Created This entails putting the investment strategy to work, investing in a portfolio that meets the client’s goals and constraint requirements.

(3) Monitor and Update the Plan Both markets and investors’ needs change as time changes. As such, it is important to monitor for these changes as they occur and to update the plan to adjust for the changes that have occurred.


Role of Asset Allocation in Investing Planning

How important the asset allocation decision to an investor?

The answer is: VERY MUCH.

A review of historical data and empirical studies provides strong support for the contention that the asset allocation decision is a critical component of the portfolio management process.

Many academics have studied portfolio performance and concluded that constructing an efficient portfolio is the key to optimizing returns for a given level of risk.

In fact, some studies have shown that up to 97% of a portfolio’s overall returns can be explained by asset allocation decisions, with security selection, market timing, and all other factors combined having a much smaller influence.


Policy Statement

An investment policy statement (IPS) is a document drafted between a portfolio manager and a client that outlines general rules for the manager.

This statement provides the general investment goals and objectives of a client and describes the strategies that the manager should employ to meet these objectives.


Input to the Policy Statement

A set of contents should be included in the policy statement.

(1) Investment Objectives: The investor’s objectives are his or her investment goals expressed in terms of both risk and returns. The relationship between risk and returns requires that goals not be expressed only in terms of returns.

(2) Investment Constraints: Certain other constraints also affect the investment plan, include liquidity needs, and investment time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences.


Need for a Policy Statement

A policy statement is a road map that guides the investment process.

Constructing a policy statement is an invaluable planning tool that will help the investor understand his or her needs better as well as assist an advisor or portfolio manager in managing a client’s funds.

There are three important reasons for constructing a policy statement:

(1) It helps the investor decide on realistic investment goals after learning about the financial markets and the risks of investing;

(2) It creates a standard by which to judge the performance of the portfolio manager;

(3) A sound policy statement helps to protect the client against a portfolio manager’s inappropriate investments or unethical behavior.


Asset Allocation Strategies

There are 5 possible asset allocation strategies;  all are reasonable and based on studies.

(1) Fixed Allocation Strategy

(2) Target Date Strategy

(3) Lifecycle Investing Strategy

(4) Stocks for the Long-run Strategy

(5) Rempel Maximum Strategy


The Best Strategy for You

The best strategy for you depends on multiple factors, including your risk tolerance, time horizon, and your long-term goals, especially your retirement goal and other factors.

That is, there is no single best strategy for all investment clients.