Modern Portfolio Theory drives strategic asset allocation, which instructs investors to focus on asset diversification as opposed to riskier market-beating strategies.
As a traditional approach to portfolio building, strategic asset allocation compels market participants to determine how much of their money should be allocated to broad investment categories, such as stocks, bonds, mutual funds or currencies. Once an investor decides on their optimal allocation, they usually stick with it for the long haul or until new information compels them to take a different direction.
Although there is no hard rule for determining your optimal asset allocation, this strategy usually begins by assessing your risk tolerance and investing timeframe.
- How much can you stand to lose in the marketplace?
- Are you willing to take higher risks for higher rewards or do you prefer stable returns at minimal risks?
- How long do you plan to stay invested?
These are just some of the initial questions you need to answer before starting the allocation process.
Answering these questions as truthfully as possible will help you or your portfolio manager determine how aggressively to invest in certain assets. Investors with a higher risk appetite and shorter investing window will usually allocate a greater share of their capital toward stocks and, within that category, high-growth sectors such as information technology and fast-growing regions such as emerging markets. On the other hand, risk-off investors with a longer timeframe may allocate a greater share of their portfolio to bonds or large-cap stocks in the S&P 500 or Dow Jones Industrial Average.
A typical strategic asset allocation breakdown is 70% stocks/20% bonds/10% cash. A similar breakdown, called 60/40, allocates 60% to stocks and 40% to bonds. Once your allocation is determined, the portfolio is rebalanced periodically to ensure that the original structure is maintained.
Strategic allocation can certainly change over time, but instances of change are infrequent. That’s because your portfolio is designed to perform during a particular market cycle, which can often last six-to-eight years or more. Changes that affect your investment goals or risk tolerance can certainly warrant revisiting your asset allocation strategy.
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