There are basically three ways to arrive at a coherent approach to asset allocation.
Strategic asset allocation
Strategic asset allocation involves the setting of long range allocations between various assets and strategies which vary little over time. Positive aspects: Easy to implement and encourages a long term orientation. Discipline is easiest to maintain. Most individual investors are best served by such an approach. While not optimal, we humans are not wired to invest in an optimal manner. Behavioral finance has cataloged many of the psychological constraints and biases which cause investors to underperform. This approach allows an investor, and their advisors, to stick to a plan and profit from the long run return of the capital markets, while reducing risk through diversification.
Tactical asset allocation
Tactical asset allocation seeks to allocate investors capital to those asset classes and strategies which have the most attractive risk and reward at any given time. This is an attempt to arrive at an optimal allocation. Of course, only a minority of investors (some would say none) are equipped to do this in a way which consistently adds value. Fear and greed are likely to dominate clear thinking and analysis. It is also difficult to maintain a long term approach, as it easily devolves into a difficult to execute form of market timing.
Synthesis
Our approach is to marry the two. An Investment Policy is developed that sets long term target ranges for each asset and sub asset class or strategy. The ranges are fairly wide and allow for us to emphasize or de-emphasize the areas where we feel it is most appropriate and is likely to add value over time. The allocation is driven by themes that we expect to materialize over a period of six months to three years. The goal is to avoid giving in to short term noise in the markets and maintain investment discipline. Shorter term opportunistic changes are typically made by the managers we hire to execute the plan who we feel can add value using approaches which are not in our own circle of competence.
To reach our clients objectives we will use a variety of vehicles.
- For income oriented investors we will use fixed income funds or individual fixed income securities depending on the client, their objectives and whether individual securities are available that are attractive and can be procured in enough variety to insure adequate diversification.
- When appropriate we will purchase individual equities for clients to reduce cost and allow for customized income and tax management.
- Exposure to traditional assets and strategies will otherwise be obtained by the hiring of money managers or the use of mutual funds which address our desired market exposure and meet our due diligence standards. These managers or funds can be either passive or active depending on our desired investment criteria.
- We will also make use of alternative investment strategies. When traditional assets are believed to be at excessive valuations, or for other reasons entail excess risk, alternative strategies may be emphasized more to make our portfolios less sensitive to market movements or to emphasize alternative sources of return. These strategies may be delivered via mutual funds, individual money managers or limited partnerships (Hedge funds, Private Equity, Managed Futures, etc.)