Asset allocation is an investment strategy that aims at balancing both risks and rewards by dividing it up and sharing it out. Gove.2009 The process creates a portfolio of assets to go according to the individual’s risks tolerance, goals and investment horizon. For instance, if Joe was risk aggressive or adventurous the investments recommended would mostly be in equity as it is the highest-class risk but receives the highest returns. However, if Joe was risk adverse ‘a cautious risker’ he would be recommended to put his money into a fixed interest rate, like guilt’s or government bonds that are stable and somewhat predictable or AAA rated bonds that contain the least amount of risk and conversely the lowest returns.
Asset allocation focuses on strategical, tactical and dynamic approaches practiced where risks are equal with less risk but a higher long-term return if assets are held individually Angelo Corelli, 2015. An approach to asset allocation is always being updated or perfected but the main approaches are; strategic asset allocation and tactical approach.
First of all, Strategic, asset allocation is a where investors take advantage of the efficiency of a fixed allocation or modern portfolio theory. On the contrary, the tactical approach is an active management portfolio strategy that changes the percentages of an asset being held in the different department in order to take advantage of market pricing anomalies.
Recent research, however, has shown that many benefits of using asset allocation have been lost as a result of oversimplified approaches and un-rigorous understandings on risk and sources of return of asset classes. Which are particularly true for structured products such as; private equity, hedge funds, real estate and commodities for instance: Numerous simplified approaches are primarily based on historical index data. However, not only have times change but so have benchmarks and Index composition.
While holding some diverse sets of assets can lower risk in certain market environments, historical evidence alone doesn’t provide enough information on which assets to hold. As research generally focuses on a limited number of asset classes (i.e. stocks, bonds, cash, real estate). Exhibited during 2008, asset classes do not provide the range of assets necessary to provide adequate diversification.
Moreover, those asset classes do not hold many of the assets or investment approaches that provide today’s investors the ability to manage risk. Just as important, many of the historical correlations reported by these asset classes are, in fact, not representative of correlations between many modern asset vehicles in current market environments. For instance, the historically low correlation numbers between stocks and bonds and real estate is due in part to the fact that real estate prices generally have not represented their true market value but their accounting value, which may not change over time, in contrast to their true sale price, which may often change over time showing an affect in investment performance over time. Similarly, private equity returns and the returns of many hedge fund strategies are models driven so are not completely reliable.
The new investment tools offered and how they are presented to investors is often based on the business model of the firm offering the investment or investment advice. Investors often fail to take into account that the underlying business models of the firms offering asset allocation advice directly impact their product mix, their approach to asset allocation, and the relative return and risk scenarios they use in their asset allocation processes.
In summary, asset allocation is a dynamic yet reflective process. While it is partly based on fundamental understandings of the underlying assets, the markets in which they trade, and the pros and cons of the various asset allocation and risk models used to manage those assets, it also requires discretion. Simple reliance on past model- based approaches, past data, or past success does not suffice. By definition, the asset allocation process assumes a change in both expectations and results. Therefore, it cannot be simply viewed against what “can and/or should happen” to asset holdings and meaningful analysis or reflection cannot be derived from simply reading as books. As they normally ignore the fundamental rules of the marketplace (e.g. the belief that certain managers can and do defy the laws of financial equilibrium and can make money in all market environments) or ignores the benefits managers may offer by suggesting that successful investment can be accomplished by simple, systematic rules- based approaches. Either approach is doomed. Neither discretion without an investment framework nor an investment framework without discretion is sustainable.
The problem of asset allocation, among the assets in the market, entails an optimization program, which maximizes the expected utility from the investment strategy as described. The investor maximizes the portfolio value given the utility function. If the investor is risk neutral, there is no need of compensation for the risk taken, and the resulting utility function is linear and directly proportional to the value of the risky asset Thomas Schneeweis, Garry B. Crowder, and Hossein Kazemi 2010.