An investment strategy that weights different assets in a portfolio according to an agreed investment policy that balances risks and returns. Percentages are allocated to each asset grouping according to a pre-determined investment strategy dependant on the investors’ risk tolerance. The allocation could be described as Cautious, Balanced or Aggressive.
Assets are grouped into “classes”- those that share similar investment properties (i.e. their responsiveness to specific economic conditions and events ). Some of these include equities, bonds, property and cash.
Other assets (Commodities, Derivatives and Private Equity for example) are considered to be “alternative assets” as they do not fit the conventional definition of an asset class but are nonetheless deemed worthy of inclusion into some portfolios (subject to risk tolerance and investment horizon criteria being met).
The most common forms of asset allocation are
- Strategic, which tends to be longer term in nature, with few changes being made in normal circumstances.
- Dynamic, which is adjusted according to changes in macro-economic trends.
- Tactical, where a shorter-term focus to allocation is adopted
- Core-Satellite, where both Strategic and Tactical allocations are made in two separate portions of the overall portfolio
Many financial experts argue that asset allocation is an important (if not THE most important) factor in determining returns for an investment portfolio.
Asset allocation is based on the principle that different assets perform differently in different market and economic conditions (i.e. are negatively correlated), providing a degree of diversification- a lower expected risk (or variation) in returns for a given level of risk.
Typically these correlations and return expectations are generated via historical data but there is no certainty that these relationships will continue into the future, meaning that there is a potential that any given asset allocation strategy may fail to deliver the targeted returns or risk parameters.
Read More about the complex mathematics behind asset allocation here.