Overview

Dynamic Asset Allocation

Asset allocation is a tool for reducing risk. To construct an asset allocation portfolio, one invests among various asset classes like stocks, bonds and cash. The returns of the asset classes tend to be affected by different factors and face different risks. Because no investment performs well all the time, when the return of one asset class is down, the fixed asset allocation approach assumes something else will be up. The rising investment may then offset the impact of the declining investment.

Traditional asset allocation uses a fixed ratio to distribute assets among different investment categories. The ratio is typically determined using parameters such as an investor’s age, financial objectives or risk tolerance. While this approach reduces risk, it does not take advantage of market conditions and leaves significant portions of the portfolio vulnerable to market downturns. The more categories used to diversify risk, the more return tends to be reduced compared to the best performing segments of the market.

Dynamic asset allocation, also called tactical asset allocation, is an active investment approach that distributes assets among the different assets classes in domestic and international equity and bond investments and money markets. That distribution is adjusted on a continuing basis in response to market and economic conditions, based on the advisor’s perception of the return potential and relative risk of each asset class.

Dynamic asset allocation, like a “fixed” asset allocation strategy, seeks to reduce risk through diversification among different investment categories. Using dynamic asset allocation, however, investors select or weigh investments based on those categories with the greatest perceived potential for superior returns, given current market conditions. The allocation of assets becomes dynamic – changing in response to market conditions and perceived opportunities for profit.

Why has dynamic asset allocation worked?

The financial markets tend to move in cycles. Over a century of market history has clearly shown that dissimilar investment categories behave differently at different times in the economic cycle. The dynamic asset allocator uses technical and/or fundamental analysis to identify where the market is in a cycle and what investment categories appear to have the strongest potential for appreciation.

The objective of dynamic asset allocation is to reduce risk by a greater amount then the return that is sacrificed and achieve real growth after taxes and Inflation. Eliminating risk from a portfolio is very easy. All one has to do is buy Treasury Bills. However, the lower risk comes with lower returns. Dynamic asset allocation is a strategy for managing risk, without unduly diminishing returns, and it works well with mutual funds. Using mutual funds in a dynamic asset allocation strategy further reduces risk by providing instant diversification across hundreds of securities within each asset class and allowing investors to flexibly move assets with little or no cost.