Strategic Asset Allocation
Asset allocation is the process of distributing the total portfolio over the asset classes. At
the stage of asset allocation, we may, for example, decide to invest 60% of our funds in
equities, 30% in bonds and 10% in money market instruments. Asset allocation does not,
however, bother about what specific shares or which specific bonds should be bought
with that 60% or 30%. That decision is left to be made in the second stage of portfolio
selection.
In some ways, this is just a change of the level of analysis. While, so far, we have talked
of the risk and return of individual securities, in asset allocation, we are talking of risk
and return for an entire asset class. Some of the techniques that we have already
discussed for individual securities can be applied directly to the asset allocation problem.
For example, the Markowitz approach to portfolio selection can be applied at the level of
asset classes by examining the historical data about the variances and covariance’s of the
returns of each asset class (Because of the smaller number of asset classes, the Markowitz
approach is, in fact, easier to apply to asset classes than to individual securities!)
Overall Portfolio Beta and Duration
However, using the insights of portfolio theory, we can simplify the asset allocation
problem even further. As far as equities are concerned, we know that:
- The most important dimension of risk is the vulnerability of the scrip to
the market factor. This risk is measured by the beta which represents the
percentage change that can be expected in the scrip price when the market
index changes by one percent. - All other sources of risk can be eliminated by holding a diversified
portfolio of scrips so that losses in some scrip will usually be balanced by
gains from other scrips. For this reason, investors should always seek well
diversified portfolios.
As regards bonds we know that:
- The most important source of risk is the changes in the interest rate. This
risk is measured by the duration. - Individual bonds are also subject to default risk, but this risk is relatively
less serious at the portfolio level.
This suggests that we can define the riskiness of the overall portfolio consisting of all
asset classes by just two measures beta and duration. Asset allocation can therefore be
carried out by deciding on the target beta and target duration and then maximizing the
expected return subject to these constraints. Before we proceed to the problem of