Asset Allocation
An Asset Class can be defined as a group of securities that tend to behave in a similar fashion relative to each other in general and are constructed and regulated by a common set of rules. Asset Allocation is the actual distribution of money across different asset classes. One of the fundamental assumptions of asset allocation is that the best-performing asset class changes from year to year and there is no reliable predictive tool for determining which asset class will be the best performer in the upcoming year. Therefore, combining the asset classes together is a prudent strategy as the non-correlating asset classes will reduce the overall volatility of the portfolio - indeed, lowering the portfolio’s variability of returns for a given level of expected long-term return is the goal of Asset Allocation. As such, this portfolio will aim to reduce portfolio return variance and increase overall long-term returns through the selection of multiple asset classes that are expected to be non-correlating or negatively-correlating, as well as having long-term net positive return expectations.
Strategic Asset Allocation
Strategic Asset Allocation refers to the basic allocation of money to the different asset classes. The basic asset allocation below reflects the mix required to achieve the long term investment objectives of the portfolio. These target allocations are derived using the fundamental principles of Modern Portfolio Theory, pioneered by Harry Markowitz in 1952. Markowitz later won the Nobel Prize in Economics for this theory in 1990.
Tactical Asset Allocation
Tactical Asset Allocation refers to the ability to adjust the strategic asset allocation based on short-, or medium-term asset class performance. For example, if the long term return on Canadian Equities is expected to be 8% and the TSX has returned four consecutive years of double digit positive returns, one could argue that in order for the index to revert to its mean will require future near-term underperformance.
If you, or you in tandem with my counsel, feel that a particular asset class has been underperforming, this IPS gives you(us) the ability to increase the allocation to that asset class to the Maximum bound. Conversely, if you, or you in tandem with my counsel, feel that a particular asset class has been outperforming, this IPS gives you(us) the ability to decrease the allocation to that asset class to the Minimum bound.
Dynamic Asset Allocation
Dynamic Asset Allocation refers to the frequency of asset class rebalancing. Specifically, since different asset classes are expected to behave in different patterns, it is possible and probable that the target Strategic Asset Allocation will be violated through normal course market movements. On a broad level, if the portfolio were to have a 50% weighting to Equities and 50% weighting to Fixed Income and through normal market movements stocks were in a bull run increasing by 20% while bonds were flat, the portfolio will have drifted to an allocation closer to 60% Equities and 40% bonds. A portfolio with an asset mix of 50% Equities and 50% Fixed Income will behave differently than a portfolio with an asset mix of 60% Equities and 40% Fixed Income, therefore it would be necessary to bring the portfolio’s overall asset allocation back in-line with the original Strategic Asset Allocation Mix.
There is a double-edged ancillary effect to rebalancing in that portfolio return variance can be reduced but long term returns may be increased OR decreased. This is due to the fact that by rebalancing back from 60% Equities and 40% Fixed Income to 50% Equities and 50% Fixed Income you are, in essence, “buying low and selling high”. For the case of the stocks which ran up 20% in short order, by selling off a portion of the equities to bring back the allocation to 50% Equities and 50% Fixed Income would represent selling at a potential high. The proceeds of the sale of a portion of the stocks would be used to purchase additional bonds, which are at a potential low (since they were flat and the expected long term performance of bonds is net positive). Constant rebalancing will serve to reduce the return variance of the portfolio. However, it should be noted that it is possible that you are selling the stocks before their bull run is over. In this case, less of your portfolio is subject to the exceptional performance that could be afforded by a stock bull run resulting in a lower potential return for the portfolio overall. Rebalancing too frequently may reduce long term portfolio return, while rebalancing too infrequently may increase the portfolio return variance. Therefore, the goal of Dynamic Asset Allocation is to find a satisfactory rebalancing strategy that finds an appropriate balance between these two opposing forces.
