In a world of financial uncertainty and ever-changing market dynamics, making the most of your extra cash requires a strategic approach. Strategic Asset Allocation (SAA) is an investment strategy that can help you grow your wealth while managing risk. In this blog, we’ll delve into the fundamentals of strategic asset allocation.
What is strategic asset allocation?
Strategic asset allocation is the opposite of just throwing your money into a few stocks and hoping for the best. It’s a well-thought-out strategy that involves diversifying your investments across different asset classes to achieve a balance between risk and return. By spreading your investments across stocks, bonds, and cash equivalents, you can potentially mitigate the impact of market fluctuations on your overall portfolio.
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What factors should I consider for my SAA strategy?
Your strategic asset allocation strategy depends on several factors such as your risk tolerance, time horizon, and investment objectives. It is also affected by stock and bond market valuations.
1. Risk Tolerance
Risk tolerance is how much risk you are willing to accept within your financial portfolio. Your risk tolerance plays a significant role in shaping your asset allocation. Consider how comfortable you are with market fluctuations and potential losses. A well-aligned strategy ensures that your investments match your risk appetite.
Risk tolerance is also affected by your age and when you need to withdraw the money. Those who are at the beginning of their careers can invest more aggressively because they still have decades to regain any losses. Those who are near retirement may need a more conservative approach to protect their money from major fluctuations.
Here are some typical asset allocations based on risk tolerance:
- Very conservative: 25% stocks, 75% bonds and cash
- Conservative: 40% stocks. 60% bonds and cash
- Moderate: 60% stocks, 40% bonds and cash
- Aggressive: 75% stocks, 25% bonds and cash
- Very Aggressive: 95% stocks, 5% bonds and cash
2. Time Horizon
Your time horizon is the period of time in which you hope to invest your money before you need it. For example, if the goal is to purchase a house, then your time horizon may only be a couple of years. Therefore, you may want to adopt a strategic asset allocation of mainly bonds and cash. Your age may also influence your time horizon.
3. Investment objectives
Make sure that you have a clear understanding of your investment objectives. Is your goal to accumulate wealth, save for retirement, save for your child’s education, or make a major purchase? Or is it to protect your money? Your goals will drive your investment strategy.
4. Stock and bond market valuations
U.S. stocks have historically returned about 10% a year over nearly the last century. But the most dangerous shortcut in financial planning is assuming that history will repeat itself. Quite the contrary. According to the data, the more expensive the stock market is, the lower its future returns. Studies show that the long-term return of stocks is highly correlated with the starting earnings yield. Earnings yield is often calculated as the inverse of the Cyclically Adjusted PE Ratio (CAPE Ratio). If the starting earnings yield is low (which happens during a booming market), the expected return of stocks will be low.
There are several ways to invest in stocks, each having its own valuation. You can invest in U.S. large company stocks, U.S. small company stocks, stocks in Europe, emerging market stocks, the list goes on.
To estimate your potential return on bonds, simply look at its current yield or yield to maturity. A 2019 Research Affiliates study showed that the subsequent 10-year return of U.S. aggregate bonds is 93% correlated with its starting yield.
5. Determine your allocation and diversify your portfolio
Asset classes include cash, bonds, or stocks. Stocks are the riskiest and cash is the least risky. The higher the risk, the greater the potential for both growth and loss. Spread your investments across various asset classes. For example, a typical diversified portfolio might include stocks for growth, and bonds for income and stability. You can also diversify within stocks (U.S. vs international, large vs small, growth vs value). You can also diversify within bonds (intermediate vs short-term maturity, federal vs municipal vs corporate vs junk bonds).
6. Regular Rebalancing
Determine how often you want to rebalance your portfolio to maintain your desired asset allocation. This involves selling assets that have performed well and buying assets that are underrepresented in your portfolio. Rebalancing helps ensure your portfolio remains within your risk tolerance. It has also been shown to improve risk-adjusted returns.
7. Consult a fee-only financial advisor
Working with a fee-only financial advisor can provide you with personalized guidance and expertise in crafting and managing your strategic asset allocation. A professional can also provide valuable perspective during periods of market volatility and help you stay on track to achieve your long-term financial goals.
What is an example of strategic asset allocation?
After a discussion with one of our clients*, we decided that the best strategic asset allocation for them according to their goals was 60% stocks, 30% bonds, and 10% cash. Their portfolio was valued at $1.5 million and it is rebalanced annually. At the beginning of the year, their portfolio looked like the below:
|Strategic Asset Allocation Weights
After one year, the stocks generated a return of 9% while the bonds generated a return of 3%. Their unbalanced portfolio looked like the below:
|Strategic Asset Allocation Weights
By following the SSA strategy, we rebalanced our clients’ portfolio to 60% stocks / 30% bonds / 10% cash. We did this by selling stocks and putting them in bonds and cash. Their rebalanced portfolio now looks like this:
|Strategic Asset Allocation Weights
*Disclaimer: This example is a hypothetical client scenario. Planning recommendations may differ from your situation. Please consult with your own financial advisor before making any changes to your strategic asset allocation.
What is the best strategic asset allocation?
There is no one-size-fits-all answer to the question of what the best strategic asset allocation is because the ideal allocation depends on individual financial goals, risk tolerance, and the current stock and bond market valuations. Many financial advisors recommend a 60/40 asset allocation between stocks and fixed income for retirees and a more aggressive portfolio for younger professionals.
What happens after I have decided on a strategic asset allocation strategy?
Once you’ve decided on an allocation, it’s important to stick with it for the long term, rather than reacting to market fluctuations. Regularly review your portfolio, typically on an annual basis, to ensure it remains aligned with your strategic asset allocation strategy. This involves selling assets that have appreciated beyond their target allocation and buying assets that have underperformed to rebalance your portfolio.
Having a strategic asset allocation strategy in place can help you avoid making emotional, short-term decisions and keep you on track to achieve your long-term financial goals. There may still be reasons that warrant a change in the allocation itself. This would be something that alters your own comfort of risk, not simply because of how those specific assets are performing.
What’s the difference between strategic asset allocation and tactical asset allocation?
Strategic asset allocation (SSA) takes a more passive approach to investing, and tactical asset allocation (TAA) involves a more active approach. They differ in terms of their objectives, time horizons, and methods. The best approach for you will depend on your investing style.
Strategic Asset Allocation:
- Objective: Create a well-diversified portfolio aligned with your financial goals, risk tolerance, and long-term horizon.
- Time Horizon: SAA is typically based on a long-term investment horizon.
- Method: SAA involves setting a target allocation for different asset classes based on your financial goals and risk tolerance. Once the allocation is established, periodic rebalancing is done to bring the portfolio back to its original allocation.
- Risk Tolerance: SAA aligns with your risk tolerance and is designed to help you stay on track with your financial objectives while managing risk over the long term.
Tactical Asset Allocation:
- Objective: Try to outperform the broader market by taking advantage of perceived market opportunities.
- Time Horizon: TAA has a more flexible time horizon compared to SAA. It involves making adjustments to the asset allocation based on changing market conditions and economic outlook. This can range from weeks to months.
- Method: TAA requires a proactive approach to monitor and respond to market changes. The assets are shifted between different asset classes based on market forecasts.
- Risk Tolerance: TAA is often associated with a higher level of risk because it involves making bets on market movements.
|STRATEGIC ASSET ALLOCATION
|TACTICAL ASSET ALLOCATION
|Proactive approach with a higher level of control
|Buy and hold strategy
|Trading when market opportunities arise
|Good for long-term investing
|Good for short-term or medium-term investing
|Best for investors who might make emotional decisions.
|Best for investors who are experienced and can have control over impulse trading
Need help with strategic asset allocation?
Strategic Asset Allocation empowers you to make informed decisions about investing your extra cash. By following a well-defined strategy that takes into account your goals, risk tolerance, and market conditions, you can position yourself for long-term financial success. Remember that investing involves risk, and there are no guarantees of returns. Consider seeking advice from a financial advisor to ensure that your asset allocation strategy aligns with your circumstances and goals.
If you are interested in a comprehensive financial plan, schedule a free discovery call with one of our fee-only financial advisors today.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.