Types of Assets Allocation

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ASSET ALLOCATION

The major activity in the investment management process is establishing policy guidelines to satisfy the investment objectives. Setting policy begins with the asset allocation decision. The asset allocation decision addresses the question: How should the portfolio’s investments is distributed among the major asset classes? In other words, what should be the mix of assets in the portfolio? The term asset allocation means different things to different people and in different contexts. We can divide asset allocation into three types:

We can loosely characterize policy asset allocation as a long-term asset allocation decision, in which the investor seeks an appropriate long-term asset mix that represents the risk and return consistent with the investment objective, seeking the greatest possible return for the appropriate level of risk. Investors often use the mean-variance portfolio allocation model in determining the policy asset allocation. The strategies that offer the greatest prospects for strong long-term rewards to accomplish the investment objectives tend to be inherently risky strategies. The strategies that offer the greatest safety tend to offer only modest return opportunities. Policy asset allocation is the balancing of these conflicting goals.

In dynamic asset allocation, the asset mix is mechanistically shifted in response to changing market conditions. Once the policy asset allocation has been established, the investor can turn attention to the possibility of active departures from the normal asset mix established by policy. That is, suppose that the long-run asset mix is established by the policy allocation as 60% equities and 40% bonds. In dynamic asset allocation, a departure from this mix may be allowed under certain circumstances. If a decision to deviate from this mix is based upon rigorous objective measures of value, we refer to this as tactical asset allocation. Tactical asset allocation, however, is not a...
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