By Anna Mabote (Portfolio Management Support at Galileo Asset Managers)

In investing, asset allocation is possibly the most effective strategy used by investment managers. It is an integral part of wealth creation and preservation. In its simplest form, asset allocation spreads your investment portfolio across several asset classes, such as equities, fixed income, real estate, cash and other cash equivalents, etc. Asset allocation helps you mitigate risks associated with investing because asset classes perform differently in various economic cycles and financial market conditions. This article will provide insight into the importance of asset allocation in investing and demonstrate the different asset allocation strategies that can be utilised to diversify and conquer financial markets with a portfolio suitable for your financial goals.

Why Asset Allocation Matters

Investing in markets may be intimidating, especially when market conditions constantly change. Since different asset classes move differently, it is nearly impossible to time the market. As a result, it isn’t easy to predict the market’s direction, even for seasoned portfolio managers. By distributing the risk across various asset classes, one may avoid trying to time the market and be confident that the risk in their portfolio is diversified to maximise returns and manage drawdowns.

When constructing a tailor-made portfolio, it is of paramount importance to have a risk assessment conducted first because one investor’s asset allocation will never be the same as another investor’s. This is primarily due to the three factors that impact an investor’s asset allocation. Let’s briefly go through those factors. Firstly, the risk vs. return determines how much risk you’re willing to take in exchange for returns. The second factor is your risk tolerance, which determines your sentiment towards risk, whether you are innately cautious (low risk), balanced (moderate risk), or aggressive (high risk). And lastly, your time horizon is determined by your investment objectives, either short-term or long-term.

Different Types of Asset Allocation Strategies

1.  Strategic Asset Allocation (SAA): This strategy has a long-term view in mind with a buy-and-hold approach and entails setting target allocations at the time of initial portfolio construction. The mix of assets in the portfolio will be rebalanced periodically to ensure that the allocations of the different asset classes don’t drastically deviate from the initially set target allocations. So, when implementing this strategy, the SAA will be used as a benchmark to monitor any deviations, allowing you to create and maintain a portfolio with the right mix of diversified assets to reach your financial objectives.

2.  Tactical Asset Allocation (TAA): More often than not, market conditions will fluctuate due to various market and economic events and impact the performances of the different asset classes in a portfolio. This is where the tactical asset allocation strategy plays a role. It enables an investment manager to make a tactical investment decision favouring a particular asset class based on challenges and opportunities emanating from economic conditions, to maximise short-term returns.

This level of flexibility carries a pinch of market-timing element and thus requires a high level of skills, expertise, and discipline. This is because the portfolio manager must be able to determine when short-term investment decisions have reached the end of their course based on their empirical research and then rebalance back to the portfolio’s long-term positioning.

3.  Dynamic Asset Allocation (DAA): This approach applies when a portfolio’s asset allocation is frequently rebalanced based on changes in market conditions, macroeconomic trends (top-down analysis), or investment opportunities. The dynamic asset allocation strategy aims to maximise potential upside opportunities for greater returns. It seeks to reduce potential downside risks by regularly rebalancing among the various asset classes. Therefore, a portfolio managed using this strategy is more actively managed since portfolio managers need to continuously monitor such portfolios and make investment decisions based on comprehensive investment research.

Conclusion:

In conclusion, asset allocation is an essential foundation in investing successfully as it provides a guideline in determining an investment solution suitable for you based on your risk assessment. Furthermore, it provides a roadmap to address and manage the complex and ever-changing world of financial markets. Asset allocation and diversification in a portfolio are crucial because they enable you to cope with the intricacies of investments with more confidence and resilience as and when the economic cycle changes. There’s really no universal asset allocation strategy since each investor has different objectives and risk profiles. So, seeking professional assistance and guidance from a financial advisor and an investment professional is recommended to help you construct and diversify your investment portfolio so that you can conquer the financial market as you strive to reach your financial goals.