The strategic asset allocation is one of the most important parts of your portfolio strategy and basically means how your money will be divided in different asset classes, usually cash, fixed income and equities. Each asset class has a certain level of risk and the more risk you take inside your asset allocation, the higher the expected return.
The strategic asset allocation that you will embrace for your portfolio must be in line with your risk tolerance and investment objectives. In addition, you should consider your expected rate of return, time horizon and macroeconomic factors.
By dividing your money in different types of asset classes, you’ll be able to minimize your risk and improve your returns.
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Diversification
One of the most important things you can do when it comes to creating your strategic asset allocation is embracing multiple asset classes in order to diversify. Diversification can minimize risk without adversely affecting return. You can reduce your risk in the portfolios by including securities that have low correlation with one another. Doing so eliminates all unique business risks associated with each individual security. You may diversify your investments by either or a combination of:
- Asset Class – having stocks and fixed income in your portfolio will diversify your portfolio
- Company Size – large cap companies are more stable than small cap companies.
- Industry – adding companies in various industry will allow your portfolio to withstand business cycles
- Geographic – investing in different countries can reduce the risk of your portfolio
- Management Style – depending on the portfolio manager’s mandate, diversification can be achieved. (Value vs. Growth)
- Maturity – Bond laddering or GIC ladder can add diversification to a portfolio. Buying fixed income instruments at different intervals
- Credit – Including companies with strong credit rating and low credit rating such as high yield bond.
Diversification vs. Correlation
Harry Markowitz preached that through diversification, an investor can reduce their portfolio risk by including investments that are not correlated with one another. He mentioned if two securities have a correlation of 0 – means that they are perfectly uncorrelated.
Correlation is simply the likelihood of two investments moving together in harmony. The higher the correlation, the more likely they are of similar characteristics. For example, the stock of Coke and Pepsi would be positively correlated as they’re in the same field and industry. These investments would have a correlation of +1.
Negative correlation is when two securities would move in opposite direction. For example, when a recession hits, gold would go up, financials would go down. These type of investments would have negative correlation of -1.
Monitoring and Re-balancing the Strategic Asset Allocation
It’s important to be aware of market changes as the asset allocation you embrace at the beginning of the portfolio might not be suitable for you in the future due to changes in your investment goals, personal goals or economic fluctuations. For example, if there is a recession coming, you may lower your risk exposure in stocks and add more fixed income to your portfolio in order to preserve your capital.
Re-balancing is an important part of your portfolio as the percentage of each asset class you have chosen may have shifted over time. For example, if you’ve indicated that you want only 20% in Canadian stocks and Canadian stocks do really well causing your strategic asset allocation percentage to go to 25%, you would have to re-balance and allocate the profit in Canadian stocks to a sector that hasn’t done that well. By doing so, you will ensure that your investments are in a diversified mix.
