Historically, common stock was deemed “per se imprudent.” The experience of the 1930s, however, proved that bonds could be risky as well. In today’s investment practices, the New Prudent Investor Rule is a pervasive guideline:
- Diversification is essential to risk minimization and is therefore, ordinarily required of trustees.
- Risk and return are so directly related that trustees have a duty to analyze and make decisions considering the level of risk appropriate to the purpose of the trust and the portfolio as a whole.
- Trustees have a duty to avoid fees, transaction costs, excessive trading, and other expenses that are not justified by the objectives of the investment product.
- The fiduciary’s duty of impartiality requires a conscious balancing of current income and growth.
- Trustees may have a duty to delegate, as prudent investors would do.
As a result, the new investment philosophy shifted the main focus of investment management from investment selection to portfolio design. Asset allocation aims to satisfy investors’ investment goals and constraints, and balance risk and reward. The asset allocation that works best for an investor at any given point will depend largely on how well the characteristics of the allocation framework match up with the investor’s investment objective, financial situation, and investment horizon.
A number of empirical studies, including Brinson, Hood, and Beebower (1986), Ibbotson and Kaplan (2000), and Brinson, Singer, and Beebower (1991), suggest that the asset allocation decision of pension plans accounted for 91.5% – 93.6% of the cross-sectional variance of returns, that is, the proportion of the variation among funds’ performance explained by funds’ different asset allocations. The remaining portion of the variance in fund returns is explained by security selection and market timing.
In real-world practice, many investors believe that the articulation of portfolio targets constitutes the most powerful determinant of investment outcomes. Thoughtful policy targets, carefully implemented and steadfastly maintained, created the foundation for investment success.
- From the standpoint of portfolio design, portfolio theory asserts that in any given period, some investment styles will be outperformers and some will be underperformers; the market goes through cycles. The addition of an investment that has a low correlation to the rest of the assets in the portfolio can reduce volatility, both on the upside and downside, thus producing a more efficient and stable return pattern.
- Investors too frequently believe that some way exists to predict which asset class will come in the first place. Beyond that, some portfolio managers indicate to investors that they have the talent to make such market-timing calls right eventually. For investors, with an appropriate asset allocation guideline in place, they can keep a long-term perspective. The history has proved that attempting to time the market can have perverse consequence.
Strategic Asset Allocation versus Tactical Asset Allocation
The major types of asset allocation are strategic asset allocation and tactical asset allocation:
The strategic asset allocation process establishes a policy mix based on the expected risk, return, and cash flow patterns of each asset class, for instance, a 70/30 stock/bond portfolio. Strategic asset allocation requires periodically rebalancing the portfolio back to these the target as investment returns skew the original allocation percentages. The foundation of strategic asset allocation lies in the Modern Portfolio Theory (MPT).
Tactical asset allocation is a moderately active portfolio management strategy. Investors utilize tactical asset allocation when they find it necessary to occasionally engage in the short-term deviations from the policy mix in order to capitalize on exceptional investment opportunities. This approach adds a market-timing component to the portfolio. It allows a range of percentages in each asset class. A major benefit of tactical asset allocation is that it provides a hedge against risk in a volatile market environment. When investors have realized the desired short-term profits, they will bring the portfolios back to the policy mix, and therefore, some investment professionals call it dynamic asset allocation.
Asset Allocation versus Diversification
Although they are offer similar benefits, asset allocation and diversification are different, and therefore, the two should be addressed concurrently but separately. Asset allocation, in its most fundamental form, is the decision of how to weigh equities, fixed income, cash, and alternative assets in a way that provides the potential for the best investment returns given the amount of risk the investor is willing to take.
Diversification, on the other hand, is to make sure that the portfolio has exposure to many different asset classes or investment styles. All other things being equal, the more dissimilarity there is among the patterns of returns of the asset classes within a portfolio, the stronger the diversification effect is in the long run. The beauty of diversification lies in the fact that its benefits are not dependent on the exercise of any superior skill; rather, it arises from the policy decision to follow a multiple-asset-class investment approach.