Strategic Asset Allocation
The goal and purpose of strategic asset allocation is portfolio optimization and risk management. Asset allocation is an investing strategy that involves dividing specific percentages of an investment portfolio among different asset categories to minimize asset correlation. Strategic asset allocation is the process of constructing an asset mix that will maximize the return of the portfolio given the amount of risk a portfolio manager is willing to accept.
Dividing a portfolio on a percentage basis among investments with asset correlations that are low allows a portfolio manager to reduce the overall risk of the portfolio. In other words, if different asset classes or categories perform differently some will be up when others are down, and vise-versa. This lowers the volatility (risk) of the overall portfolio.
Portfolio Optimization
Optimization of portfolio returns is achieved by placing a larger percentage of high return investments in the portfolio asset allocation. Because diversification and strategic asset allocation lowers volatility (risk), the portfolio manager can place more aggressive assets in the portfolio without increasing risk exposure for the portfolio as a whole. In other words, an investor that is willing to take a given level of risk can invest in higher reward/higher risk opportunities with a diversified asset allocated portfolio as opposed to a portfolio that is not.
Portfolio Risk Management
The goal of asset allocation is to combine a variety of asset categories such as cash, fixed income, domestic stocks, foreign stocks, precious metals, real estate, etc. An investment portfolio risk that cannot be attributed to the specific risk (Systematic Risk) of the individual investment is partially mitigated through asset allocation because asset categories that are not correlated will react differently to events. For example, precious metals might be up when stocks are down, or stocks might be up when bonds are down, etc. Systematic risks might include macroeconomic factors such as interest rates, inflation, recessions, wars, etc.
Diversification can nearly eliminate unsystematic risk (risk that is specific to an individual investment). A portfolio manager will want to be diversified within each asset category to mitigate specific risk. For example, if you owned stock in the oil company BP when they had their oil spill you would have been greatly harmed if that was your only stock. However, if BP was just one of 25, 50, or 100 stocks in your portfolio, the damage to your total portfolio would have been minimal.
In summary, strategic asset allocation and diversification are two key concepts of a portfolio risk management plan. Your portfolio risk management plan should include strategic asset allocation, which lowers portfolio risk caused by systematic risk, and diversification, which lowers portfolio risk caused by unsystematic risk.
Related Reading: Risk Management
| AAAMP Blog by Ken Faulkenberry | |
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Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
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