Investing can seem as daunting as navigating unpredictable seas. The highs and lows, unexpected turbulence, potential for reward, and the omnipresent risk of loss. Sailing these waters requires a sturdy and meticulously crafted strategy, one that’s built to weather the storms and seize the tranquil currents.
A critical component of this strategy is strategic asset allocation.
What is strategic asset allocation?
Strategic asset allocation refers to a long-term investment strategy. It involves diversifying your portfolio among different asset classes, like stocks, bonds, and cash, to achieve a specific financial goal while minimizing risk.
By diversifying investments across multiple asset classes, your goal is to reduce the negative impact of any single asset class on the overall performance of your portfolio.
Why strategic asset allocation is important
According to Vanguard, strategic asset allocation is important because “the mix of assets in broadly diversified portfolios is by far the greatest determinant of both total returns and return variability over the long term.”
Here are some additional reasons:
Risk Management: You mitigate risk. If one asset class performs poorly, it may be offset by another performing well. This is based on the principle that not all asset classes will move in the same direction at the same time or the same rate. It should help stabilize returns over time.
Predictability: Strategic asset allocation helps with predictability because it tends to smooth out short-term volatility and generate more consistent returns over the long term.
Discipline: Strategic asset allocation helps keep your emotions in check, especially during times of market turbulence when you may be tempted to make impulsive decisions.
Efficient Frontier: The objective of strategic asset allocation is to have an optimal combination of assets that will provide the highest expected return for a given level of risk. This concept is known as the “efficient frontier.”
Inflation Protection: Certain types of assets, like commodities or inflation-protected securities, can provide some degree of protection against rising inflation.
Diversification within Asset Classes
Strategic asset allocation doesn’t stop with diversifying across asset classes. You should diversify within each class.
With stocks, diversification means owning stocks of various sizes (small-cap, mid-cap, and large-cap companies) across multiple sectors, like technology, finance, and healthcare. It also involves spreading your reach geographically, expanding your investments beyond domestic markets into international areas like Europe, Asia, and emerging economies.
This additional diversification helps protect against sector-specific or geographic risks.
Strategic Asset Allocation is Simple
Investments like mutual funds and Exchange Traded Funds (ETFs) pool resources from many investors to purchase a diversified portfolio of stocks, bonds, and other assets, offering a ready-made diversified portfolio.
Consider low-fee Target Retirement Funds from well know fund families like Vanguard, Fidelity, or Schwab, or pre-determined asset allocation mutual funds, like Vanguard’s LifeStrategy Funds. These funds offer a range of investment options with varying risk profiles, allowing each investor to choose the one that best suits their specific needs and preferences.
“Time diversification” can be another way to mitigate risk. Regular investing a set amount over time, known as dollar-cost averaging, can minimize the risk of investing a large sum at an unfavorable time and potentially protect your portfolio against unpredictable market shifts.
Strategic asset allocation caveats
Strategic asset allocation doesn’t always work. There are times when assets which, in theory, don’t correlate will decline along with the balance of your portfolio.
Here are some examples:
The 2008 Financial Crisis: During the 2008 financial crisis, almost all asset classes suffered severe losses. However, those with a strategic asset allocation plan may have fared better than those who were overly concentrated in one asset class, particularly if that class was stocks or real estate. Bonds, for instance, typically considered a safer asset class, didn’t experience as much volatility during the crisis, which would have offset some of the losses from other asset classes for diversified investors. After the crisis, investors who stuck with their asset allocation strategy and didn’t panic recovered their losses and even made gains as the market rebounded.
The Dot-com Bubble: In the late 1990s, technology stocks soared in value. Investors heavily concentrated in tech stocks reaped significant gains during this period. When the bubble burst in 2000-2002, tech-heavy portfolios experienced substantial losses, while diversified portfolios were cushioned by their allocation to other asset classes.
The 2020 COVID-19 Market Crash: The COVID-19 pandemic hit in early 2020 and caused a rapid and severe market downturn. Both stocks and bonds suffered losses. However, the market recovered relatively quickly. Investors who maintained their strategic asset allocation approach and did not panic sell likely saw their investments recover. While strategic asset allocation can help manage risk and likely generate positive returns over the long term, it’s not foolproof. No strategy can eliminate risk or guarantee returns. All markets go through cycles of upturns and downturns, and even a well-diversified portfolio will experience periods of loss. Therefore, aligning your strategic asset allocation with your investment goals, risk tolerance, and time horizon is crucial.
