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The term “asset allocation” means different things to different people in different context. Here are some versions of asset allocation:

1. Strategic asset allocation

2. Tactical asset allocation

3. Drifting asset allocation

4. Balanced asset allocation

5. Dynamic (insured) asset allocation.

While strategic asset allocation is concerned with establishing the long-term asset mix of a portfolio, the other types of asset allocation refer to what the portfolio manager does in response to evolving market conditions.



1. Strategic Asset Allocation.

The strategic asset allocation refers to the long-term ‘normal’ asset mix sought by the investor (or portfolio manager) to achieve an ideal blend of risk and return. It may be established with the help of either an informal or a formal approach.




Informal approach.

Essentially, it involves three broad steps:

1. Subjective assess the risk tolerance as ‘low’, ‘medium’, or ‘high’.

2. Define the investment horizon as ‘short’, ‘intermediate’, or ‘long’.

3. Establish the optimal strategic asset allocation using some ‘rule of thumb’.




Formal approach.

This involves the following steps:

1. Develop quantitative forecasts of expected returns, standard deviations, and correlations of the two asset categories, viz. stocks and bonds.

2. Define the efficient frontier which contains all the efficient portfolio options available to the investor.

3. Specify the utility indifference curves reflecting the risk disposition of the investor.

4. Choose the optimal portfolio (asset allocation). The optimal portfolio is found at the point of tangency between the efficient frontier and a utility indifference curve.



2. Tactical Asset Allocation.

Tactical asset allocation involves a conscious departure from the strategic or normal asset mix based on rigorous and objective measurement of value. The objective of tactical asset allocation is to enhance the performance of the portfolio through an opportunistic shift in the asset mix in response to changing patterns of reward in the capital market. The distinctive features of tactical asset allocation are as follows:

· It is guided by objective measures of prospective values like earnings yield and yield to maturity. Hence it is essentially a value-oriented approach.

· It is inherently contrarian in nature as it involves buying after a market decline and selling after a market rise.

Note that tactical asset allocation entails market timing. The only difference between the traditional market timing and tactical asset allocation (a modern version for market timing) is that the latter is supposed to be analytically disciplined and based on objective measures of value.



3. Drifting Asset Allocation.

This policy advocates that the initial portfolio be left undisturbed. It is essentially a ‘buy and hold’ policy. Irrespective of what happens to relative values, no rebalancing is done.

For example, looking at the payoff for a ‘buy and hold’ policy if the initial stock:bond mix is 50:50:

· The value of portfolio is linearly related to that of the stock market.

· While the portfolio value cannot fall below the value of the initial investment in bonds, its upside potential is unlimited.

· When stocks outperform bonds, the higher the initial percentage in stocks, the better the performance of the ‘buy and hold’ policy. On the other hand, when stocks under-perform bonds, the higher the initial percentage in stocks, the worse the performance of the ‘buy and hold’ policy.



4. Balanced Asset Allocation:

A balanced asset allocation policy calls for a periodical rebalancing of the portfolio to ensure that the stock-bond mix is in line with the long-term ‘normal’ mix. Put differently, this policy calls for maintaining an exposure to stocks that is a constant proportion of portfolio value. If the desired constant mix of stocks and bonds is say 50:50, this policy calls for rebalancing the portfolio when relative values of its components change, so that the target proportions are maintained (constant mix policy). Thus, this policy, unlike the ‘buy-and-hold’ policy is a ‘do something’ policy’.



5. Dynamic (or Insured) Asset Allocation

Dynamic (or insured) asset allocation involves shifting the asset mix mechanistically in response to changing market conditions. For example, the fund manger may follow a constant proportion portfolio insurance (CPPI) policy. The CPPI policy calls for ‘selling stocks as they fall and buying stocks as they rise’. This implies that this policy is the opposite of the constant mix policy which calls for ‘buying stocks as they fall and selling stocks as they rise.’

Comparative Evaluation

While tactical asset allocation calls for discretionary shifts, the remaining three kinds of asset allocation, viz. the drifting asset allocation, the balanced asset allocation, and the dynamic (or insured) asset allocation involve asset-mix changes in accordance with a fixed rule. It may be instructive to compare them.

(Basically, the drifting asset allocation = ‘buy and hold’, the balanced asset allocation = ‘buying stocks as they fall and selling stocks as they rise’, and the dynamic (insured) asset allocation = ‘selling stocks as they fall and buying stocks as they rise’.)

The payoffs associated with the drifting asset allocation policy (or buy and hold policy), the balanced asset allocation policy (or constant mix policy), and the dynamic asset allocation policy (typified by the CPPI policy) are represented by a straight line, a concave curve, and a convex curve respectively.

Looking at the graphs of payoffs associated with these various allocation policies, suggests that if the stock market moves in only one direction, either up or down, the best policy is the CPPI policy and the worst policy is the balanced asset allocation policy. In between lies the drifting asset allocation policy.

However, if the stock market reverses itself frequently, rather than moving in the same direction, the balanced asset allocation policy tends to be superior to other policies.

To illustrate this point, let us look at the payoff from an initial investment of 100,000 when the market moves from 100 to 80 and back to 100 under the following three policies.

1. A drifting asset allocation policy under which the initial stock-bond mix is 50:50

2. A balanced asset allocation policy under which the stock-bond mix is 50:50

3. A CPPI policy which takes the form: investment in stocks = 2 (Portfolio value – 75,000)

The performance features of the three policies are summarized below:

1. Drifting Asset Allocation Policy (‘buy and hold’)

· Gives rise to a straight line payoff

· Provides a definite downside protection

· Performs between the constant mix policy and the constant proportion portfolio insurance policy.

2. Balanced Asset Allocation Policy (‘buying stocks as they fall and selling stocks as they rise’)

· Gives rise to a concave payoff drive

· Does not provide much downward protection and tends to do relatively poorly in up market.

· Tends to do very well in flat, but fluctuating, markets.

3. CPPI Policy (‘selling stocks as they fall and buying stocks as they rise’.)

· Gives rise to a convex payoff curve.

· Provides good downside protection and performs well in up market.

· Tends to do very poorly in flat, but fluctuating, markets.

Why Various Policies Coexist

As the market advances, investors’ wealth increases but prospective returns diminish; likewise, as the market declines, investors’ wealth decreases but prospective returns improve. Investors broadly display four kinds of responses to these changes:

A. Some investors are unaffected by fluctuations in wealth and their risk tolerance remains the same. They are the true long-term investors. When the market advances and prospective stock returns diminish, these investors increase their exposure to bonds. On the other hand, when the market declines and prospective returns increase, these investors increase their exposure to stocks. These investors naturally resort to tactical asset allocation (contrarian - buying after a market decline and selling after a market rise).

B. Other investors are mildly affected by changes in wealth. If their wealth increases, in the wake of a market advance, their risk tolerance too increases, albeit slightly. Similarly, a market decline diminishes their risk to tolerance, though slightly. These investors naturally prefer balanced asset allocation (constant mix policy - ‘buying stocks as they fall and selling stocks as they rise’).

C. Still another class of investors displays a somewhat greater sensitivity to recent changes in wealth. As the market rises, their risk tolerance increases and they feel no need to decrease their exposure to stocks, despite diminished prospective returns. Likewise, when the market falls, their risk tolerance diminishes and they feel no need to increase their exposure to stocks. These investors are the natural candidates for the policy of drifting asset allocation (buy-and-hold).

D. Finally, there is a class of investors which reacts very sharply to recent market movements. If the market rises, their risk tolerance increases sharply and they want to increase their exposure to stocks, notwithstanding the diminished prospects. If the market falls, their risk tolerance falls sharply and they want to diminish their exposure to stocks. These investors are natural candidates for a policy of dynamic (or insured) asset allocation which says “Buy after a market rise and sell after a market fall”.

Therefore, the risk tolerance of different classes of investors varies in response to recent returns. Thus we find that there are natural candidates for tactical asset allocation, balanced asset allocation, drifting asset allocation, and dynamic (or insured) asset allocation. Just as tactical asset allocation is right for some investors, dynamic asset allocation is right for others.



Reference: Investment Analysis and Portfolio Management by Prasanna Chandra (Tata McGraw Hill)