Strategic Asset Allocation (SAA) is a portfolio strategy that involves setting target allocations for various asset classes and rebalancing periodically. The portfolio is periodically rebalanced back to these targets as investment returns skew the original asset allocation percentages. The concept of strategic asset allocation can be complex, but it is a critical part of financial planning and advising. It is used by financial advisors to help their clients achieve their financial goals while managing risk.
Strategic Asset Allocation is based on the modern portfolio theory, which argues that it’s not just the individual securities within your portfolio that matter, but also how those securities interact as a whole. This theory suggests that by mixing different types of investments, you can maximize your returns for a given level of risk. This is the essence of strategic asset allocation – creating an asset mix that seeks to provide the optimal balance between expected risk and return for a long-term investment horizon.
Understanding Strategic Asset Allocation
Strategic Asset Allocation is a method used by investors and financial advisors to set an asset mix that seeks to balance risk and reward, based on an individual’s or institution’s risk tolerance, goals and investment time frame. The strategic asset allocation process involves determining what percentage of a portfolio’s funds should be allocated to different asset classes, such as stocks, bonds, and cash equivalents.
The strategic asset allocation that is right for you depends on your investment objectives, risk tolerance, time horizon, and financial situation. For example, a young investor saving for retirement might have a strategic asset allocation that is heavily weighted towards stocks, with a smaller allocation to bonds and cash. On the other hand, a retired investor might have a strategic asset allocation that is heavily weighted towards bonds and cash, with a smaller allocation to stocks.
Components of Strategic Asset Allocation
The main components of strategic asset allocation are asset classes, allocation percentages, and rebalancing. Asset classes are categories of investments that exhibit similar characteristics and behave similarly in the marketplace. The three main asset classes are equities (stocks), fixed income (bonds), and cash equivalents. Allocation percentages are the proportion of the portfolio’s total value that is invested in each asset class.
Rebalancing is the process of realigning the weights of a portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original or desired level of asset allocation or risk. For example, say an original target asset allocation was 50% stocks and 50% bonds. If the stocks performed well during the period, it could have increased the stocks weighting of the portfolio to 70%. The investor could then decide to sell some stocks and buy bonds to get the portfolio back to the original target allocation of 50/50.
Benefits of Strategic Asset Allocation
Strategic Asset Allocation offers several benefits. Firstly, it helps to reduce risk through diversification. By spreading investments across various asset classes, you can reduce the impact of poor performance by any one asset class on your overall portfolio. Secondly, it can help to achieve more stable returns over the long term. By sticking to a well-thought-out asset allocation, you can avoid the pitfalls of market timing and ensure that you are always invested in a way that is consistent with your risk tolerance and investment goals.
Another benefit of strategic asset allocation is that it can be tailored to any investment style. Whether you are a conservative, moderate, or aggressive investor, there is a strategic asset allocation that is right for you. And because strategic asset allocation is based on personal factors, it can remain consistent regardless of what is happening in the markets. This can provide a sense of stability and confidence in your investment strategy.
Limitations of Strategic Asset Allocation
While strategic asset allocation has many benefits, it also has some limitations. For one, it assumes that the future will behave like the past. This is not always the case, and sometimes an asset class that has performed well in the past may not perform well in the future. Additionally, strategic asset allocation does not take into account current market conditions. For example, if the stock market is overvalued, a strategic asset allocation approach would still call for a certain percentage of stocks in your portfolio, regardless of the overvaluation.
Another limitation of strategic asset allocation is that it can lead to sub-optimal returns. Because it involves regularly rebalancing your portfolio back to its target allocations, you may be forced to sell assets that have been performing well and buy assets that have been performing poorly. This can potentially limit your returns. However, the goal of strategic asset allocation is not necessarily to maximize returns, but rather to achieve a balance between risk and return that is consistent with your investment goals and risk tolerance.
Strategic Asset Allocation and Financial Advisors
Financial advisors play a crucial role in helping clients establish and maintain their strategic asset allocation. They work with clients to determine their risk tolerance, investment goals, and time horizon, and use this information to develop a strategic asset allocation that is tailored to the client’s needs. They also monitor the client’s portfolio and make adjustments as needed to maintain the target asset allocation.
Financial advisors also help clients understand the importance of sticking to their strategic asset allocation, even in times of market volatility. They help clients avoid the common pitfall of making emotional investment decisions based on short-term market fluctuations. By helping clients stay the course and stick to their strategic asset allocation, financial advisors can help clients achieve their long-term investment goals.
Role of Financial Advisors in Rebalancing
Rebalancing is a key part of maintaining a strategic asset allocation, and financial advisors play a crucial role in this process. They monitor the client’s portfolio and make adjustments as needed to maintain the target asset allocation. This often involves selling assets that have performed well and buying assets that have underperformed. While this may seem counterintuitive, it is a key part of the strategic asset allocation process, as it helps to maintain the desired level of risk in the portfolio.
Financial advisors also help clients understand the importance of rebalancing. They explain that while it may be tempting to let a well-performing asset run, this can lead to an increase in the level of risk in the portfolio. By regularly rebalancing, you can ensure that your portfolio remains aligned with your investment goals and risk tolerance.
Conclusion
Strategic Asset Allocation is a key component of financial planning and investing. It involves setting target allocations for various asset classes and rebalancing periodically to maintain these targets. While it has its limitations, strategic asset allocation can help to manage risk and achieve more stable returns over the long term. It can be tailored to any investment style and can provide a sense of stability and confidence in your investment strategy.
Financial advisors play a crucial role in helping clients establish and maintain their strategic asset allocation. They work with clients to determine their risk tolerance, investment goals, and time horizon, and use this information to develop a strategic asset allocation that is tailored to the client’s needs. By helping clients stick to their strategic asset allocation and regularly rebalancing their portfolio, financial advisors can help clients achieve their long-term investment goals.
