Asset Allocation

Asset allocation is the process of assigning a percentage of a portfolio to each asset class in an attempt to maximize the risk-adjusted return of a portfolio for a given investment profile. An asset allocation serves as the overall strategy for a portfolio and guides the amounts to allocate to each asset class, such as US Large Cap Equities, Small Cap Equities, High Yield Fixed Income, and alternatives, such as Real Estate. Each of these asset classes and/or additional asset classes is assigned a percentage that when taken together, coincides with your investment objectives and risk tolerance. For example, a very aggressive investor (Ultra Growth) may have an asset allocation of 95% to equities, while a conservative investor may only have 15% allocated to equities (Ultra Conservative). The table below shows the asset allocation for investors with five different investment profiles ranging from ultra-conservative to ultra-growth.

Model Portfolio Asset Allocations

An asset allocation strategy is important because it provides you with a general framework in which to make investment decisions.

Strategic vs. Tactical

Strategic Asset Allocation is asset allocation strategy can be either strategic, tactical, or a combination of both. A strategic asset allocation is the long-term asset allocation that forms the basis of your investment portfolio. For example, a Growth investor may have an allocation of 80% equity and 20% fixed income, as shown above. This allocation is maintained throughout your investment horizon or until a change in certain factors warrants a revisiting of the asset allocation. Such changes could include a change in job, the addition of a family member, a change in tax status, or any number of different factors that could affect how you should be investing.  But the strategic asset allocation is long-term in nature.

Tactical Asset Allocation

A tactical asset allocation uses the strategic asset allocation as a starting point and over weights or underweights an asset class based on the outlook for the asset class. For a Growth investor, we already determined that the strategic asset allocation was 80% to equities and 20% to fixed income. If you had a favorable outlook for equities relative to fixed income, you may decide to temporarily increase the allocation to equities to say, 85%, and the tactical asset allocation would look like the table below. Strategic vs Tactical Asset Allocation

Until your outlook changes, 85% becomes your target allocation for equities. If, on the other hand, your outlook for equities may be less favorable than your outlook for fixed income you may decide to tactically underweight equities to 75%.

Strategic vs Tactical Asset Allocation2

I want to stress the importance of underweighting and overweighting as compared to being completely in an asset class or completely out of an asset class. It is very difficult to time the market perfectly so rather than be fully invested in equities when the outlook is favorable and completely in cash when the outlook is unfavorable, it is better to over and underweight your allocation so as to have some exposure to the asset class adjusted to reflect your outlook.

Going all in to equities when you think equities will perform well and getting completely out of equities when you think they are going to perform poorly is a recipe for disaster. If you could do that successfully and consistently, you shouldn’t be reading this article. You should be sitting on a beach somewhere sipping Margaritas.


Whether you use strategic asset allocation or tactical asset allocation, the portfolio should be rebalanced at least quarterly back to the targeted asset allocation. Rebalancing will achieve two important goals in your investment process. On the one hand, you will maintain the appropriate portfolio for your investment profile. And on the other hand, you will ensure that you will always be buying low and selling high.

To illustrate asset allocation and rebalancing, I will use a simple, two asset class portfolio. Let’s say you are seeking both growth and income from your portfolio and have moderate risk tolerance to any short-term volatility in your portfolio. You decide that your asset allocation should consist of 60% equities and 40% fixed income. In a quarter in which equities outperform fixed income, it is quite possible that your allocation would end up being higher to equities than your original 60%. Let’s assume that after one quarter, your portfolio consists of 63% equities and 37% fixed income.

Asset Allocation Changes

It would be a good idea at this point to rebalance your portfolio by selling 3% in equities and reinvesting the proceeds into fixed income. Notice that by doing this, you would be selling the asset class that performed well, and buying the asset class that performed poorly (on a relative basis).  Once you have rebalanced, you will once again return to a 60% equities and 40% fixed income asset allocation.

Asset Allocation Rebalancing

A common mistake among many investors is not to rebalance in an attempt to let the good performing asset continue to ride. By not rebalancing, you risk shifting your portfolio to either a more aggressive or more conservative portfolio than your investment profile warrants. In our previous example, if you didn’t rebalance, you would end up with a more aggressive portfolio because you would have a higher percentage in equities.

Asset Classes/Choices

The asset classes that make up the components of an asset allocation can be very broad or very specific. In our example, we used equities and fixed income. This may very well be the broadest definition of an asset class. But we can also break down equities even further by sub-dividing them into US Equities and International Equities. These can be further divided into US Large Cap Equities, US Mid Cap Equities, US Small Cap Equities. And international equities can be divided into Developed Country Equities and Emerging Market Equities. The same type of breakdown can be applied to fixed income as well. It really depends on how in-depth you want to get with your asset allocation. A fairly detailed asset allocation may look like the following table:

Detailed Asset Allocation


In order to come up with an asset allocation you should first think about a few factors: target return, risk tolerance, time horizon, tax considerations, and any special situations. Realize, however that the process is more of an art than science so there is not just one single right answer. Remember that your asset allocation is not set in stone. If you come up with an asset allocation and think that it either it is not giving you enough potential return or is too volatile, go ahead and adjust it. But once you figure out what your optimal asset allocation is, make sure you stick to it and rebalance at least quarterly.

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