Asset Allocation Calculator | Strategies | Model 2022:- Once you’ve decided to start investing your money, you’ll have to decide on an asset allocation that’s appropriate for your goals, age, and risk tolerance. And unless you invest in a Target Date Fund (TDF) that automatically adjusts that asset allocation, you’ll have to rebalance your assets over the course of your investing time frame.
What is Asset Allocation
Asset allocation means that you spread your money among different assets, such as equities, fixed-income, and cash equivalents. Each of these responds differently to different trends in the market, so having a blend of them in your portfolio will help you minimize losses in a market downturn.
In general, the younger you are, the higher the percentage of equities you should own. That is because you have a longer investment period in which to make up losses if they occur, and the stock market has generally trended upward over time. More seasoned investors might have a higher percentage of fixed income holdings and might be more reliant on regular income than on big stock gains.
The Importance of Asset Allocation:-
Asset allocation establishes the framework of an investor’s portfolio and sets forth a plan of specifically identifying where to invest one’s money. Advocates conclude that proper asset allocation has the potential to increase investment results and lower overall portfolio volatility. Critics argue that the interconnectedness of financial markets
makes traditional asset allocation less beneficial. It is Baird’s opinion that both are correct – asset allocation can lead to better overall results, but the implementation needs to be flexible enough to adapt to longer-term trends in the market.
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Types of Asset Allocation
There are 3 types of asset allocation strategies:-
Tactical Asset Allocation: One of the criticisms of Strategic Asset Allocation is that it seems too rigid. From time to time, market conditions may create opportunities to get extra returns which a rigid static asset allocation strategy may not be able to capitalize on. Tactical Asset Allocation is a variant of Strategic Asset Allocation strategy wherein the investor can occasionally deviate from the long-term Strategic Asset Allocation to take advantage of market opportunities. Tactical asset allocation calls for market timing and requires considerable investment expertise. For example, your strategic asset allocation requires you to maintain a 70% equity and 30% debt mix. At a certain point in time, you think that equity can give high returns in the short term. You will tactically increase your equity allocation to 80% temporarily till you think that equity valuation is too high. The extra 10% allocation to equity will boost your returns in the short term. It is extremely important in Tactical asset allocation to know when the short-term opportunity has run its course and promptly rebalance back to target strategic asset allocation.
Strategic Asset Allocation:
In the Strategic Asset Allocation strategy, the fund has a static asset allocation mix. The static asset allocation mix in practical terms for mutual funds is usually a range, allowing the fund manager some freedom to manage the asset allocation within the specified range e.g. 65 – 75% equity and 25 – 35% debt. The fund’s mandate establishes what the ideal asset allocation mix should be and the fund sticks to it, irrespective of market movements. However, from time to time, asset rebalancing is required to maintain the mandated asset mix.
Due to price movements of different assets, the actual asset mix may deviate from the mandated mix from time to time. The fund manager then rebalances the portfolio to bring it back to its mandated asset allocation mix. For example, let us assume that the mandated Static Asset Allocation is 70% equity and 30% debt. Let us assume that the stock market rises by 25% and debt gives 6% return – the asset allocation then will be 73% equity and 27% debt. The fund manager will sell stocks and buy bonds to bring asset allocation to 70% equity and 30% debt.
Dynamic Asset Allocation: In this asset allocation strategy, you continuously adjust your asset allocation mix depending on market conditions. The most common dynamic asset allocation strategy used by mutual funds is the counter-cyclical strategy. These funds increase their equity allocation (reduce debt allocation) when equity valuations decline (become cheaper) and reduce debt allocations. This is also known as contra strategy – it essentially follows the investment tenet of buying low and selling high. Different fund managers use different valuation metrics for dynamic asset allocation, the most common being P/E and P/B ratios. Some fund managers use multi-factor asset allocation models which combine 2 or more factors e.g. P/E, P/B, Dividend Yield, etc. in dynamic asset allocation strategy.
Though dynamic asset allocation based on counter-cyclical or contra strategy is the most common strategy by dynamic asset allocation funds, other asset allocation strategies are also used. A few dynamic asset allocation funds follow a pro-cyclical strategy. The funds increase their equity allocation in rising markets and reduce it in falling markets. Some fund managers believe that following the trend is a good strategy that has worked in the past. Then there are dynamic asset allocation funds, which combine both approaches in what they call, core and tactical approach. The core portfolio (usually 70 – 80%) follows the typical valuation-based counter-cyclical dynamic asset allocation strategy, while the tactical portion follows a momentum-based approach, which is not dissimilar to the pro-cyclical strategy.
Strategic Asset Allocation:-
Dynamic Asset Allocation:-
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