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Strategic Asset Allocation: Unique in Nature, Critical for an Uncertain Future

“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 are going to explore strategic asset allocation and the benefits it can offer investors.

Most investors spend the majority 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 that must be discounted, but the other selections are more critical.

Experts argue that the selection of assets account for more than 90% of returns, rather than which security you choose.

In today’s post, we will discuss:

  • 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.

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 that 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 horizon 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. Much of the asset allocation theories are based 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 and can help reduce your risk and boost your 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 to seek to look outside of that comfort zone and find other assets outside of that realm.

The premise is in the event of a downturn, not every asset class gets punished equally, and you can improve your returns by eliminating losses. Finding yourself bottle up in one type of asset or sector can be a risk, one that I personally 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 is one of the methods. With strategic asset allocation, our approach is much more passive in nature, where tactical is much more hands-on, more actively managing your portfolio.

Strategic asset allocation is a more appropriate style if you:

  • You are 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 are looking for quality companies with a margin of safety attached and are willing to wait for the returns to come.
  • You prefer a more hands-off approach: this style of 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 downturns in the markets 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 have the ability with this style to change course as you see fit.
  • Your 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 are looking 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 sold for any reason. Of course, if something fundamental changes with the company say they decide to forgo selling iPhones, and they decide they are going to 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 are more willing to stomach, think about what Charlie Munger likes to say he sleeps like a baby at night because he is comfortable with the risk he is taking with his money. If you can remain calm when the market is falling apart, you can be more aggressive and allocate more to stocks. If you get nervous or have trouble sleeping at night from worry, then maybe a more conservative allocation to bonds or cash might be more appropriate.
  2. Your time horizon: How long do you plan to hold your investments is an important question to ask because that will have a considerable impact on your investment decisions. If you are investing for the long-term, you can be far more aggressive with your risk. In general, the longer your time horizon, the less upset you will be by the market volatility that will occur over time. If your time horizon is shorter, your tolerance for risk might be much lower, 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 setup 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 that has 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. The world of the different assets is massive, and you can mix and match 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 all of these types of diversification with the use of individual stocks, or utilizing funds such as index or ETFs. For those of you more inclined, you can look at the long-term expected returns for each asset class and the risk level that 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 if can 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, then 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 really go nuts at this stage, again 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 of your investment goals with each fund; this can be 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 oversight of the portfolio will require more attention than buying index funds, for example.

When setting up your strategic asset allocation, think about how your 401k is set up, if you are lucky enough to have one. Most 401ks are set up using 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 you can consult with a professional financial advisor at your bank.

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

Strategic Asset Allocation Examples

For our example, let’s say that Mr. Sather, who is now 65 and is five years from retirement. Mr. Sather has a conservative investment strategy at this point with a strategic asset allocation of 50% stocks, 40% bonds, and 10% cash. Assume that Mr. Sather has a $1 million portfolio, and he 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 overall value of the portfolio is now $1,072,000, with a composition of now means that equities are 51%, bonds 39%, and cash 10%.

Based on our original asset allocation, the portfolio needs to be rebalanced 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 mix of portfolio most common is 60% stocks and 40% fixed income, often referred to as 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 to 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, and 10% bonds, or even 100% stocks perfectly suitable. With the 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 of this type is not destined for long-term success. Instead, creating a plan and determining how we are going to achieve that goal is 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, and for that reason, I have to be far more aggressive, although I have a 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