“You should have a strategic asset allocation mix that assumes that you don’t know what the future is going to hold.”

Ray Dalio

Today we will explore strategic asset allocation and the benefits it can offer investors.

Most investors spend most of their time agonizing about what stock to buy or whether or not to purchase some real estate, but almost none of us think about the best way to set up our portfolio.

The majority of investment decisions revolve around these three decisions:

1. Asset Allocation
2. Market Timing
3. Security Selection

Market timing is a fool’s errand, so we must discount our investments, but the other selections are more critical.

Experts argue that asset selection accounts for more than 90% of returns rather than which security you choose.

In today’s post, we will discuss the following:

• What is Strategic Asset Allocation
• The Difference Between Tactical and Strategic Asset Allocation
• Principles of Asset Allocation
• How to Set Strategic Asset Allocation
• Examples of Strategic Asset Allocation

Ok, enough preamble; let’s dive in and learn more about strategic asset allocation.

What is Strategic Asset Allocation?

According to Investopedia:

“Strategic asset allocation is a portfolio strategy that involves setting target allocations for various asset classes and rebalancing periodically. The portfolio is rebalanced to the original allocations when they deviate significantly from the initial settings due to differing returns from the various assets.”

Breaking down strategic asset allocation means we allocate for different targets depending on several factors. The factors are risk tolerance, time horizon, and investment goals. Of course, these investment goals and time horizons may change as you move through your investment journey.

Strategic asset allocation is ideal with the buy-and-hold strategy, such as value investors employ. Many asset allocation theories base their ideas on modern portfolio theory, which emphasizes diversification to help reduce risk and maximize returns.

Much of modern portfolio theory is junk, but the basic tenet of holding different assets is a sound theory that can help reduce risk and boost returns.

When thinking about portfolio construction, try to envision not putting all of your eggs in one basket. For example, one of my challenges is focusing on financials and not seeking to look outside of my comfort zone and find other assets outside of that realm.

Not every asset class gets punished equally in a downturn, and you can improve your returns by eliminating losses. Finding yourself bottled up in one asset or sector remains a risk I try to avoid.

We will explore the different assets and some options for setting up portfolios that might suit your investment needs and risk tolerance.

What is the difference between Strategic and Tactical Asset Allocation?

The main difference between strategic and tactical remains one of the methods. With strategic asset allocation, our approach remains much more passive in nature, whereas tactical offers a much more hands-on approach, more actively managing your portfolio.

Strategic asset allocation is a more appropriate style if you:

• You operate as a buy-and-hold investor: you buy assets and hold them for a long-time, usually years if not decades. Usually, buy-and-hold investors look for quality companies with a margin of safety attached and remain willing to wait for the returns.
• You prefer a more hands-off approach: this approach buys assets with a particular mix and only buys or sells when the allocation alters from the mix. This is also known as rebalancing.
• You have a long time horizon: the longer you have for your portfolio to mature, the better your returns will be over that long time horizon. It also helps the portfolio recover from any market downturns along the way. Strategic asset allocation is perfect for those of us saving for retirement.
• You are an emotional investor: this style of investing forces you to stay with your asset allocation no matter what the market brings us. If you hop from investment to investment, this style can help you stay the course instead of freaking out at the smallest sign of distress.

The tactical asset allocation approach is perfect for those:

• You want great control: if you don’t trust the market to steer your portfolio, you can change course as you see fit with this style.
• You are willing and able to buy and sell often: if you have the temperament to trade more often and move when market opportunities present themselves.
• You have a short to medium time horizon: this style is perfect for nonretirement accounts that you want to grow but maybe not for any specific reason.

To clarify, the buy and hold option doesn’t include just buying a company, say Apple, and never selling for any reason. Of course, if something fundamental changes with the company, they decide to forgo selling iPhones and decide they will be a pizza delivery company. Then we would have to reevaluate our investment decision.

Ok, now on to set up a strategic asset allocation.

How is Strategic Asset Allocation Set?

There are seven steps to setting up a portfolio in the method of strategic asset allocation.

1. Determining your risk tolerance: by risk, we mean the amount of volatility you can stomach; think about what Charlie Munger likes to say; he sleeps like a baby at night because he remains comfortable with the risk. If you remain calm when the market continues falling apart, you can invest with more aggression and allocate more to stocks. If you get nervous or have trouble sleeping from worry at night, a more conservative allocation to bonds or cash might offer more comfort.
2. Your time horizon: How long you plan to hold your investments remains an important question because that will considerably impact your investment decisions. If you invest long-term, you can invest with far more aggression. In general, the longer your time horizon, the less upset market volatility will upset you over time. If you have a shorter time horizon, your might have lower risk tolerance, and you would want to opt for more conservative options such as fixed income or cash.
3. Factor in your investment goals: Is your goal to achieve growth of your portfolio, or is it to achieve income or set up income for the long term? Growth tends to be more aggressive, with more risk involved. Where creating income tends to be more conservative. The trick is to find the balance of both; you can achieve both with the same investment. It is finding a company that grows over a long time and creates the growth of both capital and dividends, for example. Investing in a great business with long-term growth and pays dividends is the goal of any value investor.
4. Determine what percentage you would like allocated to each asset class: asset classes typically involve stocks, bonds, and cash. Others can be included, such as real estate, private equity, gold, bitcoin, and commodities. Different assets are massive, and you can mix and match them as you feel comfortable. The trick with this step is to decide what your risk tolerance is and what you are comfortable owning. You can achieve these types of diversification using individual stocks or funds such as indexes or ETFs. For those more inclined, you can look at the long-term expected returns for each asset class and the risk level each class carries. In general, stocks are the riskiest, bonds less so, and cash the least.
5. Break down each asset class into additional categories: depending on how you want to set about purchasing, your assets will define how you break up each asset. If you are looking to invest via funds, then you can set up different funds to carry each weight of asset class; it can be as simple as buying a fund for each asset, such as a fund that buys the whole S&P 500, a bond fund, a real estate fund, and so on. Or, if you wish to invest in individual stocks, you might want to find a large-cap stock, a small-cap, international, and emerging markets, to name just a few. Breaking down each asset class can get quite granular if you wish or as simple as a few funds, and off you go. A lot of this step depends on your idea of involvement and how much control you want to have.
6. Developing a strategic asset allocation plan: In this step, we assign a different percentage to each asset we wish to have. For example, 70% stocks, 20% bonds, and 10% cash, or 60% stocks and 40% bonds. Or even more granular such as 40% large-cap, 20% mid-cap, 10% small-cap, 10% corporate bonds, 10% municipal bonds, 5% CDs, 5% cash. You can go nuts at this stage, depending on your decision of how much control you wish to have and what kind of oversight you wish to exert.
7. Buying funds or stocks based on your asset allocation plan: now, the fun part! This is where we decide what actual investments we want to buy. You can buy funds that achieve all your goals in one fund but beware of fees, the silent killers. You can also set up different index funds that accomplish all your investment goals with each fund, which we can do instead of buying individual stocks. Or you can go the route of purchasing individual companies based on your risk tolerance and what your goals might be. Using individual stocks means that your portfolio oversight will require more attention than buying index funds, for example.

When setting up your strategic asset allocation, think about how you set up your 401k if you are lucky enough to have one. Most 401ks use these different types of asset allocations and offer funds in the form of mutual or index to achieve the desired asset allocation. If you are struggling to set up your asset allocation, you can use your 401k as a guide or consult a professional financial advisor at your bank.

Ok, let’s look at some examples of how this works.

Strategic Asset Allocation Examples

For our example, let’s say that Mr. Sather is now 65 and is five years from retirement. Mr. Sather has a conservative investment strategy with a strategic asset allocation of 50% stocks, 40% bonds, and 10% cash. Assume that Mr. Sather has a $1 million portfolio and rebalances his portfolio annually.

The dollar amounts that Mr. Sather has allocated for his portfolio will be $500,000 in stocks, $400,000 in bonds, and $100,000 in cash, all based on his target allocations for the portfolio.

Over the year, Mr. Sather’s portfolio generates returns of 10% for equities, 5% for bonds, and 2% for cash. Now the portfolio amounts will consist of $550,000 in equities, $420,000 in bonds, and $102,000 in cash. The portfolio’s overall value is now $1,072,000, with a composition of now means that equities are 51%, bonds 39%, and cash 10%.

The portfolio needs to be rebalanced based on our original asset allocation to return to our initial goals. The values need to be $536,000 in stocks, $428,800 in bonds, and $107,200 in cash.

To achieve this rebalancing, we need to sell stocks in the amount of $14,000 to reduce the stock portfolio to the set amount, then we take that money and divide it between the other two assets to bring them to the desired totals. We then would allocate $8,800 to bonds and $5,200 to cash to bring both assets to our intended targets.

The above example of how the strategic asset allocation would function based on any allocation method you choose and regularly rebalancing the portfolio would achieve the desired returns.

The most common mix of portfolios is 60% stocks and 40% fixed income, often called the 60/40 portfolio. But honestly, you can alter the percentages to whatever mix suits your investment goals.

In general, the mix of assets gets more conservative as you get closer to your desired goal, retirement in most cases. Much of the time, as you get near, the percentages will flip, and fixed income might take up as much as 60 to 70 percent of your portfolio to limit the risk of a downturn in the markets as you get closer to retirement.

On the flip side, if you are younger and have a longer horizon, then setting up an asset allocation of 90 percent stocks, 10% bonds, or even 100% stocks is perfectly suitable. With a longer horizon, you can withstand any downturn in the market and enjoy the long-term benefits of compounding, the investor’s best friend.

Final Thoughts

Using a strategic asset allocation is a fantastic idea to help you structure your portfolio. Most of us focus on the actual investments and ignore the importance of setting up our portfolio based on our goals, risk tolerance, and time horizon.

Strategic asset allocation can help us avoid haphazardly establishing our portfolio and buying any asset that strikes us at a particular time. An investment process like this doesn’t have a long-term future. Instead, creating a plan and determining how to achieve that goal offers a much better process, and I think more likely to lead to success.

As someone older but started later in life have set my portfolio to be far more aggressive than is recommended at my age. But my goal is to make up for the lost time, so I have to be far more aggressive, although I plan to allocate more to fixed income in the near term to achieve some measure of safety of assets.

What is your goal, and how do you plan to achieve it? That is the goal of strategic asset allocation, and I encourage you to spend some time thinking about these ideas and putting pen to paper so that you can refer to them at any time.

That is going to wrap up today’s post, as always, thank you for taking the time to read this, and I hope you find something of value on your investment journey.

If I can be of any further assistance, please don’t hesitate to reach out.

Until next time.

Take care and be safe,

Dave