By Droms, William G.
The CPA Journal , Vol. 64, No. 9
Asset allocation is the process of distributing portfolio investments among the various available asset categories--money market instruments, bonds, stocks, real estate, precious metals and other assets. Three broad techniques for asset allocation are generally recognized. Strategic asset allocation focuses on long-range policy decisions to determine the appropriate normal asset mix. Tactical asset allocation changes the mix based on market predictions to exploit superior market predictions through such techniques as sector rotation or market timing. Dynamic asset allocation reacts to changing market conditions by making relatively frequent changes in the asset mix with the goal of combining downside protection with upside participation. Tactical asset allocation and dynamic asset allocation techniques normally are employed within the context of overall investment policy set by strategic asset allocation; they amount to variations on the theme laid out by strategic asset allocation.
For a diversified portfolio, selection of the investment asset mix--the strategic asset allocation decision--is the single most important determinant of long-term investment performance. In a widely quoted study which originally appeared in the July/August 1986 issue of the Financial Analysts Journal, Brinson, Hood, and Beebower devised a means to test the performance contribution of three activities in the investment management process: investment Policy (asset allocation), market timing, and security selection. They found investment policy dominates market timing and security selection, explaining 94% of the variation in total return for 91 large U.S. pension plans. In short, the impact of the allocation of capital among asset classes total overwhelms the impact of what particular securities the investor owns within each asset class. In a diversified portfolio, for example, the selection of specific stocks to hold within the equity portion of the portfolio will have much less impact on total performance than will the decision of what percentage of the portfolio will be allocated to equity investments relative to other asset classes.
ASSET ALLOCATION ASSUMPTIONS
The strategic asset allocation approach proposed here is based on three intuitively appealing and generally accepted assumptions. First, it is assumed that risk and return go hand-in-hand in the capital markets: the only way to increase long-run return is to move out on the risk spectrum. In terms of standard deviation of return, the higher the standard deviation of return, the riskier the investment.
The second assumption is that the capital markets are reasonably efficient over the long run and that future return spreads will be similar to historical spreads, at least in direction if not exactly in magnitude. The absolute amount of future spreads obviously will vary but one can be reasonably confident, for example, that bonds will offer higher returns than money market instruments and stocks will offer higher returns than bonds.
Finally, it is assumed market timing is not likely to enhance long-term investment results. This assumption is supported by a wealth of empirical data.
STRATEGIC ASSET ALLOCATION
The logical implication of these three assumptions is that any asset allocation model should take a long-term, strategic approach to asset allocation and any resulting portfolio should offer broad diversification among asset classes. An asset allocation system must be a function of an investor's return needs, including consideration of income and capital growth, and risk tolerance, including risk aversion, loss aversion, and liquidity preference. Risk aversion is the classical hypothesized behavior of the "rational economic person" faced with making a decision involving risk. The rational economic person is assumed to make investment choices that maximize expected return at any given risk level or, alternately and equivalently, minimize risk at any given return level. …