Asset Allocation Modeling: The Foundation of a Solid Investment Strategy
Asset allocation modeling is a complex process frequently employed by financial professionals and portfolio managers that uses mathematical formulas and algorithms to help investors create tailored investment strategies in an effort to minimize risk and maximize potential gains.
This is done by strategically distributing a client’s assets among different types of investments to balance risk and return while working to achieve the client’s stated financial goals. These assets include stocks, bonds, cash, money market securities and, where appropriate, alternative investments.
Asset allocation modeling attempts to forecast how various assets might perform under fluctuating market conditions given a client’s financial goals and risk tolerance. This stratification of assets into various asset classes provides a vital foundation for any long-term investment strategy, as it can help manage volatility and improve growth potential over time.
There are three main approaches to asset allocation modeling–strategic, tactical, and dynamic–and we’ll explore the significance of each in this article.
The Importance of Asset Allocation Modeling in Investing
Given the market’s unpredictable nature, the best we can hope for as investors is to balance risk with reward. This can be done, in part, through asset allocation modeling, which tailors investment selection to financial goals and risk tolerance.
A primary goal of asset diversification is to spread risk more evenly across investments. Therefore, asset allocation modeling is an essential investment strategy when it comes to portfolio performance and long-term wealth building.
Overall, asset allocation modeling can help investors simplify the investment process and curb impulsivity when navigating overwhelming market conditions. It provides a mathematical guide on how much to allocate to each asset class given client objectives, time horizon, and risk tolerance.
Common Asset Allocation Models
Strategic Asset Allocation
This asset allocation model creates a long-term investment strategy that rarely changes due to short-term market fluctuations. For example, if the model projects diversifying in stocks and bonds, the percentage of each allocation will not change much over the years.
A 60/40 portfolio – 60% investment in stocks and 40% in bonds – reflects this allocation model. One goal of this type of strategy is to preserve wealth with slow, steady growth.
Tactical Asset Allocation
The tactical asset allocation model is the opposite of the strategic asset allocation model, since it responds to short-term market fluctuations and changes. It is designed to focus on immediate opportunities for wealth growth.
For example, an investor may choose to increase stock allocation investments if the market seems to outperform or shift to bonds if it is likely to underperform. This strategy can be
characterized as a medium to higher risk strategy meant to synergize some wealth preservation with growth opportunity.
Since tactical allocation relies heavily on market shifts, both an 80% stock / 20% bond portfolio and a 20% stock / 80% bond portfolio are prime examples of this investment approach.
Dynamic Asset Allocation
The dynamic asset allocation model is similar to tactical allocation but includes more frequent adjustments to portfolios based on market performance and economic conditions.
The active adjustment of portfolio allocations to meet changing market conditions can take a great deal of time and resources, and its success depends on making allocation changes at the right time. A primary goal of dynamic asset allocation is to capitalize on short-term market opportunities.
Factors Influencing Asset Allocation Decisions
Investment Goals
Investment goals are a major factor in determining asset allocation, as they greatly influence the level of risk considered acceptable and which assets are ultimately chosen. Investment goals depend on many personal factors and often change over time due to lifestyle and financial shifts.
Time Horizon
The client’s age and the time horizon of financial goals also have significant influence over how assets are allocated. Whether the client is aligned with a short-term, long-term, or balanced approach will shape how a portfolio is managed over time.
Risk Tolerance
Another important factor that determines asset allocation decisions is the client’s level of risk tolerance. Risk tolerance is usually tied to investment objectives and client age (typically, the closer to retirement, the more risk-averse the investments become).
Market Conditions
Asset allocation is vastly influenced by current and projected market conditions, which may help forecast which assets are more likely to provide the best return on investment. If the market conditions are volatile, a portfolio manager will most likely recommend less risky investments, and vice versa.
Tax Considerations
Clients also need to understand the implications that taxes may have on the invested assets. If taxes are an issue for long-term financial objectives, then investing in tax-efficient assets or in a tax-sensitive fashion may take priority.
This tax-friendly strategy could include placing tax-inefficient investments, such as bonds or REITs, in tax-advantaged accounts, or choosing to invest in tax-efficient assets such as index funds and bonds.
Key Steps to Develop an Asset Allocation Model
Define Investment Goals
Defining your investment goals is the first step to understanding your investment strategy, as it informs all the other steps in asset allocation modeling. What are your financial goals and in which time frame do you want to achieve them?
Analyze Market Conditions
Next, you’ll have to analyze market conditions to understand how best to achieve your investment goals within the current financial landscape. If you’re looking to invest in tactical or dynamic assets, forecasting short-term market conditions is vital.
Choose Asset Classes
Depending on your investment goals and the market conditions, you can then look for the assets that you anticipate will help you meet your goals.
Diversify Within Asset Classes
Diversifying within stocks, bonds, cash, and money market securities can reduce the impact of a market downturn, which balances out potential gains and losses.
Select Allocation Ratios
Once you find assets that fit your goals, decisions are then made to determine the appropriate percentages to allocate to each. Depending on your risk tolerance, age, and other personal factors, you might want to invest higher percentages in either lower or higher-risk assets.
Monitor and Adjust
Lastly, monitoring your investment portfolio will help you understand market trends, your short-term returns on investment, and whether you’re still on-track to achieve your financial goals. This real-time knowledge can further guide you in adjusting your asset allocations and investment strategy moving forward.
Common Pitfalls to Avoid in Asset Allocation Modeling
Chasing Market Trends
Losing sight of long-term market returns and focusing solely on chasing short-term trends can lead to unnecessarily high-risk behavior and may result in significant investment losses.
Emotional Decision-Making
Emotional decision-making should be avoided when it comes to investing, since emotions are not informed by data or long-term projections. If you feel you are easily swayed by alluring market trends, make sure you sit down with a financial professional first before making any impulsive decisions, especially during times of market volatility.
Neglecting Rebalancing
Since personal factors and risk tolerance can change over time, neglecting to review and rebalance your assets can compromise your investment goals. Set a timeline to regularly revisit your investment strategy to help ensure you stay on track with reaching your financial goals.
Liquidity Needs
Your liquidity needs will change as your life priorities shift. If you foresee the need to dip into your investments for cash, advance planning will help ensure that cash is available to meet your liquidity needs.
ACG’s Asset Management Strategy
Asset allocation modeling is the foundation of a solid investment strategy, providing a balanced approach when it comes to risk and return. When done thoughtfully, it can help investors navigate market volatility and position their investments for long-term growth.
At Atlanta Consulting Group (ACG), our experienced financial professionals seek to simplify the complexity that comes with asset management and help our position clients for long-term success in reaching their financial goals. Contact us today for help with your asset allocation modeling.