'Asset Allocation' is explained in detail and with examples in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Asset allocation involves diversifying an investor portfolio into a variety of different assets based on the appropriate level of risk. This procedure has investors divide up their investments between varying types of assets. Among these might be stocks, real estate, bonds, and cash.
The goal is to maximize the reward and risk balance using the investors’ own goals and scenarios. This has become one of the critical ideas behind money management and financial planning today. There are several different types of asset allocation to consider. These are strategic, tactical, and dynamic.
In strategic asset allocation, the investor sets out target allocations for the desired different classes of assets. When the percentage balance deviates from the original set levels, it will involve the investor rebalancing the overall portfolio. The allocations will be reset to the original ones as they change significantly because of different returns that each class earns.
Strategic asset allocation sets these initial allocations up using a number of different considerations. Among these are the investor objectives, the intended time frame of investing, and the risk tolerance. These allocations can be changed in time as the different variables alter.
A good comparison to this form of allocating is a traditional buy and hold investment strategy. This form of strategic allocating of assets and the tactical allocation approach are both derived from modern portfolio theory. They seek diversification so that they can lower risk and boost the returns on portfolios.
Tactical asset allocating is more active than strategic forms of the discipline. Investors who follow tactical allocating will re-balance the asset percentages in different categories on a more regular basis. They will do this in an effort to benefit from market sectors that are stronger or poised for gains. They might also re-balance in an effort to capture anomalies in market pricing.
Tactical allocating is well suited to professional portfolio managers. They study the markets and look to find extra returns from scenarios that develop. This is still only considered to be a strategy that is moderately active. When the short term gains are attained, these managers go back to the original strategic asset balance of the portfolio.
Investors or managers who look for tactical asset allocators often choose ETF exchange traded funds or index funds for this purpose. The goal of these vehicles concentrates on asset classes rather than individual investments. This reduces the costs of rebalancing. The transaction costs of buying and selling index funds is far less than with many individual stocks or even several mutual funds.
For an individual investor, they allow them to pick a stock index fund, bond index fund, and money market fund. It is also possible to focus on sub-sectors within the bigger funds. There are foreign stocks, large cap stocks, individual sectors, and small cap stock funds or ETFs from which to choose.
When tactical allocating in sectors, investors can pick out those which they believe will perform strongly for either the near term or intermediate time frames. Those that believe health and technology will do well in upcoming months or even a few years might rebalance some of the portfolio into ETFs in those industry segments.
With dynamic asset allocation, investors are focused on re-balancing the portfolio to keep it near its long term goals of asset mix. This means that positions in assets classes that are outperforming have to be reduced. Those that are under-performing must then be increased with the proceeds from the outperforming assets. This restores the portfolio mix to the desired allocation. The reason investors would do this is to keep the original asset mix so that they can capture appropriate returns that meet or beat the target benchmark.