4 types of asset allocation for ensuring optimal level of risk & return

Asset allocation is key to investing success and its importance cannot be stressed enough. Balancing risk and reward by investing in different asset classes, asset allocation helps stabilize your portfolio.

However, did you know there are different types of asset allocation strategies? Read on to find out.

Strategic Asset Allocation
This type of asset allocation adheres to a static mix that is very much practical in terms of mutual funds. It allows the fund manager some flexibility to manage investments in different asset classes - say 75% in equity and 25% in debt. The fund’s mandate establishes the asset allocation mix, and the fund sticks to it.

Due to price movement, the actual asset mix may deviate from the fund’s mandate. The fund manager rebalances the portfolio and brings it back to its original state. This asset allocation is similar to the buy and hold strategy in stocks and bonds.

It enforces discipline in investments and makes sure you will not make wrong decisions under greed or fear. This is a long-term strategy, and you should go for it after factoring in your risk tolerance and investment time frame.

Tactical Asset Allocation
In the long run, a strategic asset allocation may seem too rigid. During your investment journey, market conditions may create opportunities to generate extra returns.

Having a strategic asset allocation mix may not help you encash on this opportunity. This is where tactical asset allocation comes into play where you deviate from strategic asset allocation.

For example, suppose your strategic asset allocation requires you to maintain 70% in equity and 30% in debt.

Now at any point, if you feel that equity can give higher returns in the short term, you increase the equity allocation to 80% and maintain it until equity valuations seem too expensive. The extra 10% in equity will boost returns in the short term.

Tactical asset allocation, however, requires timing the market. For this, you need considerable investment experience.

Dynamic Asset Allocation
In dynamic asset allocation, you adjust your asset allocation mix as per the prevailing market conditions. With this strategy, you sell assets that decline and purchase the ones that increase.

Dynamic funds follow this strategy where the asset mix constantly shifts between equities and debt.

Most funds increase equity allocation when valuations are low and vice versa.

Some funds, however, increase equity allocation in a rising market and reduce it in falling markets. Fund managers use different strategies such as P/E and P/B ratios to determine asset allocation.

Insured Asset Allocation
Insured asset allocation requires you to establish a base portfolio value below which your portfolio shouldn’t drop. As long as your portfolio achieves the returns above the base value, you deploy an active management strategy to enhance its value as much as possible.

However, if the value drops, you invest in risk-averse assets for the base value to get fixed.

This type of asset allocation is suitable for investors who desire a certain level of active portfolio management but don’t want their portfolio value to drop beyond a certain value.

Conclusion
Asset allocation plays a crucial role in ensuring the optimal level of risk and returns. While framing your asset allocation strategy, consider various things such as your investment goals, risk tolerance, and investment horizon. Investing in asset classes with low correlation is the key to a successful plan.

(The author is President & Head, Personal Wealth, Edelweiss Wealth Management)