Determining your portfolio goals and risk tolerance is the first step in creating an investment strategy. The next step is to deploy the investment strategy by mapping out an asset allocation. The allocation is the mix of asset classes and the corresponding individual stocks and bonds, investment funds, or instruments you will invest in.
When you work with an investment advisor, this process can be tailored to your goals and risk tolerance. It will include a long-term plan and a series of smaller tactical shifts that are meant to help the portfolio meet return goals while staying within risk parameters.
Key concepts we’ll cover: Strategic Allocation, Tactical Allocation
The Strategic Allocation
The “Strategic Asset Allocation” represents the portfolio’s relatively long-term goals and risk tolerance. It is usually planned to map to a given stage of the business cycle, which can last for 5 to 10 years. As long as the economy and the markets remain stable, rebalancing to ensure that the portfolio remains within the strategic allocation as asset prices change over time is usually done annually.
The strategic allocation begins with deciding your return objectives and risk tolerance and selecting a portfolio that will work to achieve your desired return without exceeding your risk tolerance.
The strategic allocation is expressed as a percentage of bonds, stocks, and cash. By having investments that react differently to the same market conditions, the expectation is that all positions in a portfolio will not be up or down simultaneously. Over the investment horizon, poor returns in one asset may be offset by good returns in another.
For illustration purposes, we’ll look at a “moderate” risk portfolio –that combines 60% equities and 40% fixed income. The investments are further spread amongst sub-asset classes within each asset class, providing additional diversification across different geographies or other characteristics. Each of these investments is given a desired weighting in the portfolio based on its risk/return expectation. A benchmark is determined for each.
For example, the equity portion of the 60/40 portfolio wouldn’t just be invested in one stock or even one sub-asset class of stocks, such as Large Caps. It would be split among several and might look like this:
The largest holding is U.S. Large Cap Equity. Still, Mid Cap, Small cap, International, and Emerging Markets all have a role in creating a portfolio that can be managed towards a desired return/risk profile.
Tactics Can Add Value
While the strategic allocation remains static, markets move all the time, driven by economics, technological innovation, geopolitics, and other variables. These moves can create opportunities for returns missed by the broader allocation. Adjusting long-term target portfolio weightings for a short period to capitalize on these opportunities and then resetting to the target weights is the Tactical Asset Allocation.
A Short-Term Play
This sounds complicated, but it just means shifting money from one investment to another, depending on what is likely to generate the best performance in the short term. In the sample portfolio above, a tactical shift could be increasing the portfolio’s holdings of small-cap stocks if the Federal Reserve were to begin cutting interest rates. Historically, small caps have done well when interest rates drop.
Tactical shifts are not meant to be significant changes – usually, they are under 10% of the total weighting. However, they require skill to manage, so they are usually best implemented in a portfolio by either a financial advisor or an automated, quantitative model.
Constructing a portfolio that meets your goals and fits your risk profile requires a combination of skill, knowledge, and a deep understanding of you as an investor. Your investment advisor can work with you to determine the best mix of assets for you at each stage of your life and in each phase of the business cycle. Keeping your portfolio attuned to short-term opportunities and avoiding temporary pitfalls can add significantly to your portfolio’s value.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risk a d return. If applicable, historical discussions or opinions are not predictive of future e events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or financial l advice. Please consult a legal, tax, or financial professional for information specific to your situation.
Reviewed by FINRA.