Asset allocation involves allocating investment portfolios among different asset classes, such as cash, bonds, stocks, derivatives and mutual funds. Small business owners can choose between different asset allocation methodologies for their personal or business investment portfolios. Strategic asset allocation involves setting an asset mix for the long-term with periodic adjustments, while dynamic asset allocation involves frequent portfolio adjustments to respond to changes in market conditions.
Strategic Asset Allocation
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Strategic asset allocation starts with a target asset mix based on an investor's expected rate of return and risk tolerance, and the long-term performance of different asset classes. Investment portfolios are periodically rebalanced to restore the target asset mix. For example, if the target asset mix of a conservative investment portfolio is 10 percent cash, 30 percent stocks and 60 percent bonds, changes in global markets could cause the stock component to rise to 40 percent of the portfolio and the bond component to fall to 50 percent. Rebalancing could involve selling some stocks or buying additional bonds to restore the target 30-60 mix of stocks and bonds. In other words, rebalancing is done to restore a long-term target, not to respond to market conditions.
Dynamic Asset Allocation
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Dynamic asset allocation may involve several portfolio adjustments over the short term to respond to market conditions. There is no target asset mix because portfolio managers can change allocations based on their assessments of current and future market trends. For example, if global market uncertainties result in sharp losses in the equity markets, investment managers may sell stocks and buy bonds because fixed income instruments, especially government-issued bonds, are considered low-risk investments. Investment managers can generate high rates of return if they are right on their expectations of market trends and if these trends persist over long periods. However, dynamic asset allocation could underperform market averages, especially in volatile markets, because of high trading costs associated with frequent portfolio rebalancing.
Tactical Asset Allocation
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Tactical asset allocation involves actively looking for short- and intermediate-term undervalued and overvalued assets, and moving between asset classes to take advantage of these market inefficiencies. Tactical asset allocation relies on the fact that markets sometimes tend to overreact. For example, a bad earnings report from one technology company could hurt all technology stocks, which could represent a good buying opportunity.
Considerations
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Small business investors may also use passive asset allocation, which usually involves constructing investment portfolios that mimic benchmark indexes. Passive asset allocation strategies generally cost less than active allocation strategies in terms of research and trading costs. However, the rate of return is tied to the index, meaning the investor has limited control over the portfolio performance.
