Asset Allocation Investment Strategy (Models, Strategies, Portfolios, Analysis, Returns)

Asset allocation is the allocation of investments across different classes of assets. In a broad sense, this means a combination of stocks, bonds, various securities and money market instruments.

Within these classes, subclasses are also distinguished:

  • Stocks of companies with a large market capitalization: Over $ 10 billion;
  • Stocks of mid-cap companies: From $2 billion to $10 billion;
  • Small-cap stocks: Less than $2bn. These stocks tend to have a higher risk due to their low liquidity;
  • International securities: Any security issued by a foreign company and listed on a foreign exchange;
  • Securities of companies from developing countries: These investments offer high potential returns and high risk;
  • Securities with a fixed income: Corporate or government bonds with a high ratings, which pay the holder a certain amount of interest, periodically or at the end of the period. These securities are less volatile and less picky than stocks;
  • Money market: Investing in short-term debt securities, usually a year or less. Treasury bills are the most common money market investment;
  • Real Estate Investment Trusts (REITs): Stocks in an investment pool of mortgage loans or real estate.

Risk and return

The purpose of asset allocation is to minimize risk while achieving an acceptable level of return. Knowing the risk and return characteristics of different asset classes is necessary to achieve this goal.

Stocks have the highest potential for returns but also the highest risk. Treasury bills have the lowest risk because the government backs them but also provides the lowest return.

This is proved by centuries of data:

Asset allocation strategy returns and performance

The tables above are taken from Credit Suisse Global Investment Returns Yearbook 2023, showing the nominal and real returns in the USA and UK. Bills, the shorts duration bonds, have the lowest returns (as expected).

The rule of thumb is that an investor should gradually reduce risk over many years to retire with a reasonable amount of money invested in safe investments.

To simplify the asset allocation process for clients, many investment firms create a series of model portfolios, each consisting of different proportions of asset classes. Each portfolio satisfies a certain level of investor risk tolerance. In general, these model portfolios range from conservative to very aggressive. Let’s look at them one by one:

Conservative portfolio strategy

Conservative model portfolios typically allocate a large percentage of the total low-risk securities such as fixed-income and money market securities.

The primary purpose of a conservative portfolio is capital protection. That is why these models are often referred to as “capital preservation portfolios”. This is mainly for people who are already rich or are approaching retirement age.

Even if you are very conservative and tend to avoid the stock market entirely, remember that investing in stocks can help offset inflation. You can invest some of your capital in blue chips or an index fund (ETF).

Moderately conservative portfolio strategy

A moderately aggressive portfolio is suitable for an investor who wants to retain a large portion of the portfolio’s total value, but is willing to take on some risk to hedge against inflation. The overall strategy within this level of risk is called “current income”. With this strategy, you select securities with high dividends or coupon payments.

Moderately aggressive portfolio strategy

Moderately aggressive portfolios are called balanced portfolios, because the composition of assets is divided almost equally between fixed income securities and stocks. It’s a balance between growth and income.

Since moderately aggressive portfolios have a higher level of risk than conservative portfolios, this strategy is best suited for investors with a longer time horizon (usually more than five years) and an average level of risk tolerance.

We believe an example of such a strategy is the famous 60/40 portfolio.

Aggressive portfolio strategy

An aggressive portfolio consists mainly of stocks, so its value can fluctuate a lot from day to day. If you have an aggressive portfolio, your main goal is to achieve long-term capital growth. Hence, the aggressive portfolio strategy is often referred to as the “capital growth” strategy. To provide diversification, investors with aggressive portfolios usually add some fixed-income securities.

An example could be Warren Buffet’s 90/10 portfolio, which we backtested at the end of the article.

Very aggressive portfolio strategy

A very aggressive portfolio consists entirely of stocks. With a very aggressive portfolio, your goal is strong capital growth over a long period of time. In the short term, the value of such a portfolio can vary greatly.

Conclusion on model portfolios

These model portfolios and strategies are just your starting point in building your own. You can change the proportions according to your individual investment needs.

You can always adjust the proportions and periodically adjust your strategy depending on how your life, needs, and priorities change.

But even if your priorities haven’t changed, one day, you may find that your portfolio is out of balance.

For example, if a moderately aggressive portfolio has accumulated a lot of stock gains lately, you can move some of those gains into safer money market investments.

Asset allocation is a very important part of creating and balancing an investment portfolio. After all, this is one of the main factors that affects your profits more than the choice of individual stocks. Creating an appropriate balance for your investments in stocks, bonds, currencies, and real estate is dynamic. Thus, the set of assets should reflect your goals at any given time.

Below, we have outlined several different asset allocation strategies based on their main management approaches.

Strategic asset allocation strategy

This is a basic method based on a proportionate mix of assets based on expected rates of return for each asset class. You must also take into account your risk tolerance and investment timing. You can set your goals and then rebalance your portfolio from time to time.

This method is similar to the buy-and-hold strategy, and also involves a lot of diversification in order to reduce risk and increase profitability.

For example, if stocks have historically given an average annual return of 10% and bonds an average of 5%, then a 50/50 combination would mean a return of about 7.5% per year.

Constant-weighting asset allocation

Strategically, this approach implies a “buy and hold” strategy, even if the value of assets deviates from the initial values. With this approach, you are constantly balancing your portfolio.

For example, if the value of one asset goes down, you buy more of it. And if it increases, you sell it.

There are no hard and fast rules and no time frame for rebalancing. But the general rule of thumb is that a portfolio should be balanced to its original proportions when any asset class changes in price by more than 5% of its original value.

Tactical asset allocation strategy

In the long run, strategic asset allocation may seem relatively rigid. Therefore, you may find it necessary to occasionally engage in short-term, tactical diversions in order to capitalize on unusual or exceptional investment opportunities.

A tactical asset allocation can be:

  • Discretionary – when the investor regulates the distribution process;
  • Systematic – where an investor capitalizes on inefficiencies across asset classes.

This strategy can be moderately active, since all proportions are restored after reaching the desired short-term profit.

It requires a certain discipline. You must first be able to recognize when short-term opportunities have exhausted their potential, and then rebalance the portfolio for the long term.

Dynamic asset allocation

This is another active strategy. You constantly adjust your asset mix as markets rise and fall and the economy strengthens and weakens. According to this strategy, you sell those assets that are falling in price and buying those that are rising.

Dynamic asset allocation is based on the portfolio manager’s judgment, not on a target set of assets.

This fact makes this strategy the polar opposite of the “constant weighing” strategy.

For example, if the stock market shows weakness, you sell stocks in anticipation of a further decline, and if the market is strong, you buy stocks in anticipation of a continuation of growth.

Insured asset allocation

You set a base value for the portfolio, below which it must not fall. As long as the equity is above this value, you actively manage, relying on analytical research, forecasts, judgment, and experience, to decide which securities to buy, hold, and sell to maximize the portfolio’s value.

If the portfolio drops to the underlying value, you invest in risk-free assets such as Treasury bonds. Thus, the base cost becomes fixed. At this time, you consult with your advisor to understand how to reallocate assets, perhaps even completely changing your investment strategy.

This technique is suitable for risk-averse investors who desire a certain level of active portfolio management but value security.

Integrated asset allocation strategy

This is where you consider both your economic expectations and your risk when creating a set of assets. While all of the above strategies take into account expectations of future market returns, not all of them take into account the investor’s risk tolerance. But the complex distribution includes aspects of all the previous ones and takes into account everything.

But it cannot include both dynamic and constant weight distribution since an investor would not like to implement two strategies that compete with each other.

Conclusion on asset allocation strategies

Asset allocation can be active to varying degrees or strictly passive. An investor’s choice of the exact asset allocation strategy or a combination of different strategies depends on the investor’s goals, age, market expectations, and risk tolerance.

How to choose the best asset allocation model

We have reviewed the main asset allocation strategies. Based on them, you can create and stick to your own. You need to understand 4 basic models on which everything is built.

When it comes to investing, there is no one right answer. Each model emphasizes different aspects of investing – one will work better in some markets, but not so well in others.

The basic idea is to create a portfolio using a model that includes all four models, but in different proportions based on your preferences.

Let’s look at each of the four asset allocation models, keeping in mind that none of them is and should not be universal.

Income model

The income-focused asset allocation model is an investment that generates returns with minimal risk of loss due to market fluctuations.

It is important to remember that this approach involves investing in various assets, which will include a certain degree of risk, at least a minimal one, as well as a small chance to participate in the market’s growth. For this reason, the performance of this model should be better than a bank deposit.

Here are some of the assets that fit this model:

  • Government bonds and treasury bills with various maturities;
  • Corporate or municipal bonds;
  • Stocks with a high dividend yield.

Please note that although this model emphasizes the return on all assets in the portfolio, it does not exclude small losses, because stocks and bonds still depend on market factors and the issuer’s financial position.

However, due to the slightly higher risk, such a portfolio should provide at least a slightly higher return than a bank deposit.

Growth and income model

The growth and income model works the same way as the income model, emphasizing making a profit on all investments. The main difference is what assets the investment portfolio consists of.

The income portfolio tends to emphasize the security of capital first, the growth and income model implies not only income, but also the potential to increase the value of portfolio assets. Therefore, the emphasis is on dividend stocks and to a lesser extent, on treasury securities and bonds.

The idea is to generate a stable income – for example, dividend income by investing in stocks. This will allow the portfolio to generate capital appreciation and stable income.

Done right, this asset allocation model can be one of the best in the long run. Because stocks that not only regularly pay dividends, but also constantly increase them, have historically been one of the best investments.

Growth model

Under the growth model, investments are made primarily in equities. The portfolio may contain stocks with dividend income, but the focus will be on companies with above-average growth potential. Many of these stocks will not pay dividends at all.

Money is usually invested in blue chips with a history of growth. Some funds may lie in bonds in order to sell them in the future and buy additional stocks.

A growth-focused asset allocation model may also include a certain number of stocks in the portfolio that fall into the aggressive growth category: stocks that fall into the high return/high risk category.

Aggressive growth model

The aggressive growth model is investing in high-yield/high-risk stocks. They may not generate any dividend income and may not be blue chips.

These are stocks of companies that most investors consider speculative.

Such investments can work well in a rising market, but are often subject to steep pullbacks in a falling market.

For this reason, aggressive growth patterns are primarily targeted at young adults with a high risk tolerance.

Which model suits you

You may think that you know which of these models to build your investment strategy on, but in fact, there are some objective factors to consider in order to determine what is best for you:

  • Determine your risk tolerance. If high volatility causes you to wake up at night, then either the income or growth and income models will suit you. If the prospect of making huge profits inspires you, and the potential losses along the way do not bother you much, then your model is a model of growth or even aggressive growth. But first, you need to determine how much risk you can handle.
  • Define your goals and time horizon. If your goal is to retire at 30, you can and should pursue a growth or aggressive growth strategy. The returns on such investments can be impressive. On the other hand, if you are planning to save money to buy a house within five years, you need to be more conservative. You cannot afford to suffer losses. In this case, the “income” or “growth and income” models are preferred.
  • Choosing a combination of assets. Once you have determined your risk tolerance, investment objectives, and time horizon, you can begin to decide which asset types will perform best in your portfolio.
  • Establish a rebalancing schedule. After the initial allocation of assets in the portfolio, you will need to make a rebalancing schedule. This is to ensure that each asset class always has its share of the portfolio. This is especially important in a “growth and income” model where you’re trying to balance the two. At a minimum, rebalancing should be done once a year.

Asset allocation strategy backtest

Let’s end the article by providing an example of an asset allocation strategy. We backtest Warren Buffett ETF portfolio (90/10).

The Warren Buffett ETF Portfolio (90/10) involves putting 90% of capital in low-cost, passively managed S&P 500 index ETFs and 10% in government bonds.

This strategy is based on Warren Buffett’s investment philosophy, which is well-known for favoring passive investing and steering clear of expensive actively managed funds. Comparatively speaking to actively managed portfolios, the strategy seeks to offer long-term growth with lower risk and fees. We would label Warren Buffet’s ETF portfolio as an aggressive allocation strategy because the bond component is small.

We made two backtests of the portfolio:

Asset allocation strategy backtest 1

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This is the equity curve (compared to buy and hold SPY):

Asset allocation strategy

The red line shows SPY (buy and hold), while the blue line is 10% allocated to SHY and 90% to SPY. As expected, it performs slightly worse compared to SPY:

90% SPY and 10% SHYBuy and hold SPY
CAGR9.13%9.8%
Max drawdown50%55%

Asset allocation strategy backtest 1

In our second backtest, we allocate 90% to SPY and 10% to TLT (iShares 20+ Year Treasury Bond ETF):

Asset allocation strategy performance

The red line shows SPY (buy and hold), while the blue line is 10% allocated to TLT and 90% to SPY. The portfolio performs better than the two others and is almost at par with SPY.

90% SPY and 10% TLTBuy and hold SPY
CAGR9.62%9.8%
Max drawdown50%55%

Longer maturities pay you for the additional risk, according to the backtests (as expected). Moreover, the SPY/TLT strategy has often outperformed investing 100% in SPY. The terrible bond market in 2022 was the cause of the underperformance.

List of investment strategies

We have written over 1200 articles on this blog since we started in 2012. Many articles contain specific investment rules that can be backtested for profitability and performance metrics.

The trading rules are compiled into a package where you can purchase all of them (recommended) or just a few of your choice. We have hundreds of investment ideas in the compilation.

The strategies are taken from our landing page of investment strategies.

For a list of the strategies we have made, please click on the green banner:

These strategies must not be misunderstood for the premium strategies that we charge a fee for:

FAQ:

What is asset allocation?

Asset allocation is a strategic investment approach that involves spreading investments across different asset classes to achieve a diversified portfolio. The goal is to balance risk and return by investing in a mix of assets with varying levels of volatility and potential for growth. This method acknowledges that different asset classes respond differently to economic events, helping investors navigate market fluctuations while pursuing their financial objectives.

How does asset allocation strategy minimize risk and achieve returns?

Asset allocation minimizes risk by diversifying investments. Different asset classes react differently to market conditions. While stocks may be volatile, bonds and fixed-income securities offer stability. By spreading investments, the impact of a poor-performing asset is mitigated by the performance of others. Returns are achieved by aligning the portfolio with the investor’s risk tolerance, financial goals, and market conditions.

What is the significance of risk and return in asset allocation?

The risk and return relationship is fundamental in asset allocation. Stocks, with higher potential returns, carry higher risk. Bonds, with lower risk, offer more stable returns. Balancing these factors helps investors create portfolios aligned with their risk tolerance and financial goals. Understanding the risk-return trade-off is essential for optimizing the portfolio’s performance.

Asset allocation strategy (strategies)

We have provided several examples of backtested asset allocation strategies. Please click the link below:

We have written even more investment strategies on this page.

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