Which of the Following Portfolio Construction Methods Starts with Asset Allocation?

Portfolio construction is a dynamic and evolving process that revolves around the delicate balance between risk and return. The approach to constructing a portfolio can differ greatly depending on the goals of the investor, risk tolerance, time horizon, and other individual factors. In this article, we will dive deep into various portfolio construction methods and reveal which of them starts with asset allocation as the foundational step. But before we answer that question directly, let's understand what asset allocation is and why it's so important.

What Is Asset Allocation?

Asset allocation is the process of dividing an investment portfolio among different asset categories such as stocks, bonds, real estate, and cash. The goal is to maximize returns for a given level of risk, or minimize risk for a given level of expected return. The premise of asset allocation is that different asset classes react differently to the same economic events, meaning that by combining them, investors can reduce volatility and potentially increase returns over time.

Now, you might be wondering—what makes asset allocation so critical in the context of portfolio construction? Here’s why:

Asset allocation accounts for over 90% of portfolio performance. Research shows that the majority of a portfolio’s returns are driven by the allocation between different asset classes, rather than individual security selection. This is a key takeaway for anyone serious about investing.

The Importance of Starting with Asset Allocation

When you start by determining your asset allocation, you're focusing on your risk tolerance, goals, and investment time horizon. This step forces you to think critically about what you're trying to achieve and what risks you're willing to take. It's also where you establish a diversified approach, spreading your investments across different asset types to mitigate risk.

So, which portfolio construction method starts with asset allocation?

The Method: Strategic Asset Allocation

Strategic Asset Allocation (SAA) is the portfolio construction method that starts with asset allocation as the foundational step. In this method, an investor begins by determining the ideal asset mix based on their long-term goals, risk tolerance, and time horizon. Once this allocation is set, it generally remains consistent, with only minor adjustments made over time. The strategy focuses on maintaining this allocation by periodically rebalancing the portfolio, ensuring that the investor's portfolio stays aligned with their original risk and return expectations.

Understanding Strategic Asset Allocation

In Strategic Asset Allocation, you establish a long-term target for each asset class (e.g., 60% stocks, 30% bonds, and 10% cash). The weights are chosen based on the investor's objectives, such as generating returns for retirement, preserving wealth, or funding a major expense in the future. The idea is to determine the mix that provides the best possible return for a given level of risk.

Once the initial allocation is determined, the portfolio is periodically rebalanced to maintain the target allocation, as market movements can cause the portfolio to drift away from its intended balance. For example, if stocks perform exceptionally well and now represent 70% of the portfolio instead of 60%, the investor will sell some of their stock holdings and buy more bonds or cash equivalents to bring the portfolio back into alignment.

Why Is Strategic Asset Allocation So Effective?

1. Consistency: By sticking to a long-term allocation strategy, you avoid the temptation to chase trends or make decisions based on short-term market fluctuations.
2. Risk Management: The process of periodic rebalancing ensures that you do not end up with an overly risky portfolio due to market movements.
3. Diversification: The initial asset allocation ensures that you're spreading your risk across multiple asset classes, protecting your portfolio from significant losses in any one area.

Other Methods of Portfolio Construction

While Strategic Asset Allocation begins with asset allocation as its foundation, there are other methods of portfolio construction, each with its own advantages and disadvantages. Here's a quick look at some of them:

1. Tactical Asset Allocation

Tactical Asset Allocation (TAA) is a more active approach compared to SAA. Instead of sticking rigidly to a pre-determined asset mix, investors using TAA will adjust the allocation based on short- to medium-term market forecasts. The idea here is to capitalize on market opportunities or avoid potential risks as economic conditions change.

For example, if an investor believes that equities are undervalued and poised for growth, they might temporarily increase their allocation to stocks. Similarly, if they expect a downturn in the market, they might move more assets into bonds or cash.

While Tactical Asset Allocation can potentially yield higher returns than a strict SAA approach, it also requires more frequent decision-making and involves a greater degree of market timing, which can be risky.

2. Core-Satellite Approach

The Core-Satellite Approach is a blend of both Strategic and Tactical Asset Allocation. In this method, the "core" of the portfolio is allocated using Strategic Asset Allocation principles, typically with low-cost, broad-market index funds that provide long-term stability. The "satellite" portion of the portfolio is then actively managed, using Tactical Asset Allocation strategies to take advantage of short-term opportunities.

This approach allows investors to benefit from the long-term stability of a strategically allocated core portfolio, while also pursuing additional returns through active management in the satellite portion.

3. Dynamic Asset Allocation

Dynamic Asset Allocation (DAA) is another active portfolio construction method. Unlike Tactical Asset Allocation, which typically involves short-term adjustments, Dynamic Asset Allocation involves making continual, long-term adjustments based on changing market conditions. This method is highly responsive to market shifts and can result in frequent changes to the portfolio.

Dynamic Asset Allocation often takes into account macroeconomic factors, such as interest rates, inflation, and overall market trends, when determining the best asset mix.

4. Constant-Weighting Allocation

Constant-Weighting Allocation is a simpler form of asset allocation where the investor maintains a constant percentage allocation to each asset class, rebalancing frequently to return the portfolio to its original allocation. This method is less about market timing and more about discipline, ensuring that investors don't deviate from their original asset mix due to market fluctuations.

For example, if an investor decides on a 70/30 stock-bond mix, they will rebalance the portfolio whenever market movements cause it to drift from this target, regardless of broader market conditions.

Why Asset Allocation Matters More Than Ever Today

In today’s rapidly changing global economy, asset allocation is more important than ever. With rising inflation, volatile markets, and economic uncertainty, investors must think carefully about how they structure their portfolios. Here are some factors making asset allocation even more crucial today:

• Inflation: Rising inflation erodes the purchasing power of cash and can have a negative impact on fixed-income investments like bonds. This makes it essential to consider how much of your portfolio is allocated to inflation-protected assets like commodities or real estate.
• Globalization: As the world becomes more interconnected, events in one region can have ripple effects across the globe. A diversified asset allocation that includes international investments can help manage this risk.
• Technological Disruption: With rapid technological advancements reshaping entire industries, it’s important to include growth-oriented investments like tech stocks or venture capital in your asset allocation strategy.

Conclusion: Start With Asset Allocation to Build a Resilient Portfolio

If you're serious about building a portfolio that can weather economic storms, generate long-term returns, and align with your personal risk tolerance, Strategic Asset Allocation should be your starting point. It is the method that begins with determining the right mix of assets based on your goals and constraints, allowing you to craft a well-balanced, diversified portfolio.

While other portfolio construction methods like Tactical or Dynamic Asset Allocation may offer more flexibility and the potential for short-term gains, they also come with greater risks and require more active management. For most investors, starting with a solid asset allocation plan and sticking to it through periodic rebalancing is the most reliable way to achieve financial success.

2222: Portfolio construction is key to success, and starting with the right allocation sets the stage for long-term success.