7.2 Asset Allocation Strategies - 7.2 Asset Allocation Strategies Explained

Key Concepts

• Diversification
• Modern Portfolio Theory (MPT)
• Core and Satellite Strategy
• Lifecycle Funds
• Tactical Asset Allocation
• Dynamic Asset Allocation

Diversification

Diversification involves spreading investments across various asset classes to reduce risk. By investing in different types of assets, such as stocks, bonds, and real estate, investors can mitigate the impact of poor performance in any single asset class.

For example, if you invest only in technology stocks and the tech sector experiences a downturn, your portfolio could suffer significant losses. However, if you diversify by also investing in bonds and real estate, the impact of a tech downturn would be less severe.

Modern Portfolio Theory (MPT)

Modern Portfolio Theory, developed by Harry Markowitz, suggests that the risk and return characteristics of an investment should not be viewed in isolation but rather as a whole portfolio. MPT aims to maximize returns for a given level of risk by combining assets with low correlations.

Think of MPT as building a balanced meal. Each food group provides different nutrients, and combining them ensures a well-rounded diet. Similarly, combining assets with low correlations ensures a balanced portfolio that maximizes returns for a given level of risk.

Core and Satellite Strategy

The Core and Satellite Strategy involves dividing the portfolio into two parts: the core, which consists of low-cost, diversified investments, and the satellite, which includes higher-risk, higher-reward investments. The core provides stability, while the satellite aims for growth.

Consider the core as the foundation of your house, providing stability and security. The satellite is like the decorative elements that add style and potential value. By combining both, you create a balanced and potentially rewarding portfolio.

Lifecycle Funds

Lifecycle Funds, also known as target-date funds, automatically adjust the asset allocation based on the investor's target retirement date. As the target date approaches, the fund shifts towards more conservative investments to preserve capital.

Imagine lifecycle funds as a GPS for your retirement journey. The closer you get to your destination (retirement), the more conservative the route becomes to ensure a safe arrival.

Tactical Asset Allocation

Tactical Asset Allocation involves making short-term adjustments to the portfolio based on market conditions and economic forecasts. This strategy aims to capitalize on market opportunities while managing risk.

Think of tactical asset allocation as navigating a ship. Just as a captain adjusts the course based on weather conditions, a tactical asset allocator adjusts the portfolio based on market conditions to reach the desired destination.

Dynamic Asset Allocation

Dynamic Asset Allocation involves continuously adjusting the portfolio based on changing market conditions and investor needs. This strategy requires active management and monitoring to ensure the portfolio remains aligned with the investor's goals.

Consider dynamic asset allocation as a gardener tending to a garden. Just as a gardener adjusts watering and pruning based on the plants' needs, a dynamic asset allocator adjusts the portfolio based on market conditions and investor goals to ensure healthy growth.