Mastering Strategic Asset Allocation: The Key to Long-Term Investment Success

Strategic asset allocation is a buy-and-hold strategy. This method establishes a “base policy mix”, where a portfolio is structured based on a proportional combination of assets on expected rates of return for each asset class. A manager holds the policy portfolio in appropriate weights at all times without active deviation and rebalances back to prescribed weights on a regular basis.

The 60% equity 40% fixed income balance portfolio is a common policy portfolio for private investors.

Practitioners of SAA implicitly expect assets to respond in specific ways to different market environments. For example, they expect government bonds to do well when the economy is doing poorly and inflation is low, and they expect stocks to respond positively to economic growth. Also, they expect stocks to be more volatile than bonds, and they expect them to move to the beat of different drummers.

Traditional investors who employ Strategic Asset Allocation (SAA) are essentially basing their decisions on significant assumptions about the expected long-term returns, risks, and correlations among the assets within their portfolio. They are also making crucial choices regarding which assets to incorporate and which to exclude. When they limit their investment universe, such as focusing primarily on domestic stocks and bonds, as is common for many investors, they expose themselves to the potential cost of missing out on returns from alternative sources.

The trouble with SAA, as it is typically applied, is that investors utilize estimates based on long term average observations from history to create their optimal portfolios.

Volatility

Although assets typically demonstrate a long-term pattern of volatility, the actual volatility levels for all assets can significantly deviate from their average state periodically. For instance, while the average 60-day volatility for equity indices is approximately 16% on an annualized basis, there are instances where stock volatility can drop to less than 10% in stable, upward-trending markets, or spike to over 70% in turbulent bear markets.

This exerts a significant influence on the risk characteristics of a standard balanced portfolio, consequently affecting the overall experience of the typical balanced investor.

Correlations

“correlation” refers to the statistical measure of the degree to which the prices or returns of two or more financial assets move together or relate to each other.

Correlation is quantified via a statistic called the correlation coefficient, which varies between -1 (moves in opposite directions) and +1 (moves in the same direction). A coefficient of 0 indicates no relationship.

A common misconception is that US stocks and US treasuries are negatively correlated, and as a result an investment portfolio with both assets will have lower volatility.

However, while the long-term correlation between U.S. stocks and Treasuries are low or even negative over the long term, the actual realized correlation between these assets oscillates between strong and weak over time (-0.70 to +0.30)

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