Diversification, also called asset allocation, is a crucial risk mitigation strategy for every investor. By spreading your investment capital among different asset classes, you can insulate your portfolio from market fluctuations. For example, the financial losses from poorly performing stocks could be offset by gains from a high-performing real estate investment portfolio.
The tricky part is deciding how to diversify. There are multiple asset allocation models to help you choose an asset mix that works for you. One of the most popular options is called strategic asset allocation.
In this article, we’ll explain what strategic asset allocation is, share the factors that influence strategic asset allocation, and help you set your own strategic asset allocation. We’ll also provide some alternative asset allocation models in case strategic asset allocation doesn’t sound like the best fit for you.
Here’s everything you need to know about strategic asset allocation.
What is Strategic Asset Allocation?
Strategic asset allocation is a long-term investment portfolio strategy that involves establishing a suitable asset mix based on investment goals, risk tolerance, and timelines.
This strategy is more passive than other asset allocation models because it does not require investors to continually monitor performance or constantly buy and sell assets. Instead, you set your asset mix upfront and allow your portfolio to grow without too much interference.
Rather than reviewing your portfolio monthly (or even weekly) and making adjustments, strategic asset allocations investors review their portfolios annually and rebalance as needed to fit the originally selected asset mix.
Factors That Influence Strategic Asset Allocation
Investors who choose the strategic asset allocation model take three factors into account when selecting their assets and setting their allocations:
Investment Goals. Investors can choose different assets based on objectives like cash flow and appreciation. Dividend-producing stock, for example, is often used for generating passive income while non-dividend-producing stocks are typically held for value growth over time.
Risk Tolerance. Investors can decide how much risk they are comfortable taking with their assets. Generally, higher risk means higher reward potential. For example, opportunistic real estate investments offer high returns with moderate risk, while core investments offer moderate returns with low risk.
Timeline. Investors who plan to hold assets for decades invest differently than those who plan to liquidate their investments within a few years.
How to Set Your Strategic Asset Allocation
There are five steps to establishing a strategic asset allocation that works for you:
Step 1: Determine Investment Goals
Define your financial objectives. Are you looking to grow the value of your portfolio over time, generate cash flows, or simply preserve your capital? Perhaps you’re looking for a combination?
Maybe you want to preserve 10% of your capital, grow 20%, and generate income from the remaining 70%. There are no wrong answers, so long as you set a goal for each asset in your portfolio.
Step 2: Assess Risk Tolerance
Decide how much risk you are willing to take. Every investor’s risk tolerance level is different. Some investors want to play it safe with 10%, accept moderate risk with 40%, and take more risk with the remaining 50%. Other investors would be more comfortable applying 10% to higher risk, 50% to moderate risk, and 10% to low risk.
Your risk tolerance may directly correlate with your investment timeline as we’ll discuss next.
Step 3: Define the Timeline
How long do you plan to hold your investments? Longer time horizons typically allow for more aggressive investments. This is because investors can ride out any temporary market dips with long-term investments. On the other hand, if you plan to cash out your investments in the next five years (perhaps for retirement or another big lifestyle change), you may want to stick with more moderate investments that are less volatile.
Step 4: Select Asset Classes and Set the Allocation
With your goals, risk tolerance, and timeframes established, you can choose the types of assets to include in the portfolio. Common asset classes include:
Stocks. Domestic, International, etc.
Bonds. Treasury bonds, municipal bonds, etc.
Funds. Index funds, mutual funds, exchange-traded funds, etc.
Alternative investments. Art, collectibles, cryptocurrencies, hedge funds, etc.
Derivatives. Options, futures, etc.
Some classes are riskier than others. Derivatives, for example, are typically more volatile than commodities. Stocks are typically riskier than bonds. However, some classes offer a wide range of investment vehicles, each with its own benefits and risk profiles.
In this step, you will decide how to allocate your assets. Here are a few examples:
10% to bonds, 30% to stocks, 60% to real estate
25% to alternative investments, 25% to funds, 50% to real estate
10% to derivatives, 10% to cash equivalents, 30% to real estate, 25% to stocks, 25% to bonds
You don’t have to know everything about every investment option available. Some investors get caught in the analysis paralysis trap at this stage and procrastinate. You’re almost always better off investing in something (anything) than letting your cash sit in a bank account, losing value to inflation. Your choices don’t have to be perfect; you just need to choose.
Step 5: Periodically Review and Rebalance
As mentioned, strategic asset allocation is about choosing an asset mix that doesn’t have to be constantly adjusted. Many investors simply review and rebalance once a year.
Portfolios become unbalanced when one asset class naturally outperforms another. Imagine, for example, that your strategic asset mix includes 50% to stocks and 20% to bonds. Now, assume that your stock holdings grew by 15% this year while your bonds grew by only 5%. Suddenly, stocks account for more than 50% of your portfolio. So, to bring the ratios back in line, you sell some stock and invest that capital into bonds until your portfolio is “rebalanced” to the original allocation.
Your annual review is also a good time to make sure you’re satisfied with your assets’ performance. If one asset consistently underperforms, you may opt to sell that asset and invest the proceeds into a different asset in the same class.
Example of Strategic Asset Allocation
Let’s assume an investor has $50k to allocate. Based on their goals, risk tolerance, and timeframe, they decide on the following strategic asset allocation: 50% to real estate, 25% to stocks, and 25% to bonds.
There are five common alternatives to strategic asset allocation:
Tactical Asset Allocation. Tactical allocation represents short-term deviations from your normal asset allocation strategy. For example, a unique short-term opportunity may come up that doesn’t fall within your strategic asset allocation. You might choose to tactically deviate from your original plan to take advantage of this opportunity.
Dynamic Asset Allocation. Dynamic allocation is when investors continually monitor market conditions and make portfolio adjustments accordingly. Dynamic investors sell assets in decline and buy assets on the rise. The idea is that declining investments should be disposed of before the value drops further and money should be funneled toward investments that are gaining in value.
Constant-Weighting Asset Allocation. Constant-weight allocation also requires investors to continually watch the market and make adjustments. But instead of selling assets in decline and buying assets on the rise (like with dynamic allocation), constant-weight investors buy assets in decline and sell assets on the rise. The idea is that you can get a good deal by buying assets when the value is low, and then selling when the value increases.
Insured Asset Allocation. Insured allocation is for risk-averse investors. It centers around a base portfolio value. As long as the value exceeds your minimum acceptable value, you invest aggressively. But if the market shifts, and the portfolio dips below the base value, you immediately funnel your assets into risk-free investments (like treasury bills) to protect your capital.
Integrated Asset Allocation. Integrated allocation is the term for any combination of other allocation models. For example, an investor might use a mix of dynamic asset allocation and insured asset allocation.
Include Passive Real Estate Investments in Your Asset Allocation
One option that is skyrocketing in popularity is real estate syndication. Like crowdfunding, syndication pools funds from multiple investors to finance a professionally managed real estate project. Unlike crowdfunding, syndication offers a stable legal structure in which equity investors are made members of the ownership entity. This gives each investor an ownership stake in the underlying real estate.
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