Strategic Asset Allocation

The purpose of shopping for deals, be it for small items like clothing or big purchases like appliances or cars, is to try to optimize a purchase by saving money on the value received from the item. So whether you're using coupons or your negotiating power, you want to get a great deal subject to the amount of money you have to spend. When it comes to strategic asset allocation or the policy portfolio, you'll want to do the same thing: maximize value. But instead of budget issues, there are other factors that play a role in the asset allocation process. What other factors impact the strategic asset allocation?

No. Most assets around the world are available to investors through funds and markets.

That's not it. The amount of money isn't a real factor in the asset allocation process because it doesn't limit asset allocation.

That's right! Risk tolerance and investment constraints act as a "budget" on the asset allocation process by providing guidelines for you to incorporate into your investing decisions. So you need to work within these constraints to maximize the investor's value or utility. According to utility function, the optimal asset allocation provides the highest utility to the client over the client's time horizon subject to the investment constraints and investor's risk tolerance.

For example, in mathematical terms, the goal of asset allocation in utility terms is to maximize the expected utility of ending wealth by allocating 100% of assets subject to restrictions on these asset weightings. So essentially, the utility function incorporates factors that drive the value of ending wealth. These factors are asset class weightings, beginning wealth, and a third that should help compound the investor's value over time. What's the third factor that should receive a value from the utility function?

No. The risk-free rate doesn't drive compounding of assets.

That's right! Asset class returns are the third factor that receives a weighting from the utility function because asset class returns determine part of the ending value for the investor. So overall, utility function will weight the probability of occurrence for the ending portfolio value by factoring in beginning wealth, asset class weight, and asset class return. The overall weighting of these ending values determines the expected utility.

Not quite. Global equity market betas aren't the only factor that determines the compounding of assets.

Speaking more directly, you want to use an asset allocation that meets the investors' overall objective while considering their constraints. And that's really the first step in selecting a specific strategic asset allocation strategy. It all starts with an investor's objective, like paying for college, retirement spending, or paying down debt. From there, the next order of steps really falls in line with an investment policy statement. The IPS will set an initial objective (the first step) and then work through various constraints, starting with one that impacts both the level of return and level of change in the account's value. What constraint could that be?

No. Taxes aren't the primary factor in growing the account because taxes are only a withdrawal on the value.

You got it! Risk tolerance impacts the asset allocation in numerous ways, like the percentages allocated to stocks versus bonds. So it's important to determine the investor's risk tolerance and the method to express and measure this risk. Another crucial constraint is the time horizon, which can limit the ability to take risk if it's short. There are also tax, regulatory, legal, political, and personal constraints that must be taken into consideration.

Not quite. Regulatory factors are important, but those don't truly impact a portfolio's volatility.

Together, these constraints flow into the determination of which asset allocation strategy is most appropriate (asset only, liability relative, or goals based). But be careful not to identify an asset allocation strategy solely based on the client type; sometimes asset allocations strategies will fit multiple clients with various situations. It's not one size fits a certain client. From there, asset classes are specified, capital market expectations are set, and potential asset allocation ranges are developed for presentation to the client. The final steps are to simulate the potential outcomes from the various asset allocation ranges and work with clients to select an asset allocation that matches their situations.

To sum it up: [[summary]]

Assets available to the investor

Amount of money the client has to invest

Risk tolerance and investment constraints

The risk-free rate

Asset class returns

Global equity markets beta

Taxes

Risk tolerance

Regulatory factors

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