Risk Parity Basics: Strategic Asset Allocation

Time for another addition to the Risk Parity Basics library for those getting started with portfolio construction. This time: strategic asset allocation. What is it? What types are there? How can it help investors?

A few months back, I posted about rebalancing and included a handy spreadsheet to help investors with this task of portfolio management. A little bit later, I offered an updated version of the tool, for those who wanted to include a cash allocation in their portfolios. But lately, I have been wondering if I was skipping a crucial concept for investing beginners: the overall structure of a portfolio that would then call for rebalancing in the first place.

So, to take a step back to make sure all readers of this blog have a solid baseline to start with, in this post, I’ll cover the overall strategy that an investor would use rebalancing to accomplish. That is strategic asset allocation, a portfolio approach where the investor sets targets for different asset classes and then tries to maintain those targets as the portfolio goes forward.

To be clear, all RP strategies that I have ever heard of involve strategic asset allocation of one shape or another (more on that later), though not all strategic asset allocation strategies are Risk Parity. In fact, most aren’t. It is such a key part of the RP framework, though, that it really can’t be skipped.

What is Strategic Asset Allocation?

Imagine a shoe store that wants to always have a variety of sizes on hand so that they can sell to all customers. For men’s shoes, they might have the largest allocations in size 10, since this is the most common size, though they’d also have lots of 9s and 11s. They’d want to carry a few size 13s and even 14s, though they wouldn’t allocate too much warehouse space to them, since the number of customers with feet that size are less common. If, for some reason, the store sold a bunch of size 8s in a given month, their next factory order would be higher for size 8 to replenish their stock going forward. If months pass without ever selling a size 15, then they’d have no reason to add that size to the order. In other words, the shoe store would have a target allocation of different sizes, based on their assumptions, that they would hew to more or less throughout the year.

Now think of that with different assets instead of shoe sizes. An investor might decide that the right portfolio for them going forward would be 50% in stocks, 30% in bonds, and 20% in gold. These would be their targets, and as the assets moved up or down over time, the assets would drift away from these starting targets, and could then be brought back in line by adding to what is low and subtracting from what is high. That process of bringing the assets back into proportion is known as rebalancing, which is a huge topic in and of itself.

Investopedia has a great explanation of strategic asset allocation, and also has an embedded video which is great for visual learners:

Strategic Asset Allocation
Strategic asset allocation is a portfolio strategy whereby an investor sets target allocations for various asset classes and rebalances the portfolio periodically.

The Types of Asset Allocation

The first type is called static: once your asset allocations are set, you don’t change them. The 50/30/20 example we used above would stay 50/30/20 even with a huge pullback in one element, say bonds. This is sometimes known as a countercyclical strategy, since your rebalancing would generally be done in opposition to the main market sentiment. If bonds crashed so that they were now 15% of your portfolio, you’d move against the main sentiment to actually buy more of them. This can be hard to do - why pour more money into a declining asset? But it's also the best way to “buy low, sell high.” When something falls, you buy more of it; when something rises, you sell it to claim your profits.

In the real world, static doesn’t mean perfectly static, though, or that once you set an allocation, you are stuck with it for decades. You can still have a plan to gradually migrate over time, but this is more to keep up with changing investing priorities, rather than any prediction about the assets. Someone in their 60s would want less exposure to risk than they had in their 40s, and you can construct an asset allocation glidepath to get from one allocation to the other over time. In this case, they may be 50/30/20 in their 40s, and then 30/40/30 by age 65, with pre-planned changes to move X percent every five years or so. To me, if the changes are thought out ahead of time, and are based on long-term investor needs and not short-term changes in asset performance, they’d still be considered a type of static asset allocation.

Dynamic is when you would change target allocations based on recent performance. In risk parity, the goal is to maintain a balancing of risks between asset classes, and when one is tanking, that means it is exposed to more risk, and in response, the risk-balanced portfolio would need to allocate less to this now more-volatile asset. This approach is procyclical, meaning it would try to adapt and move with changes in the market in order to maintain a consistent risk exposure. This approach robs you of the benefits of “buy low, sell high,” but on the plus side, can theoretically be more stable, as you pull resources from assets when they are in the midst of big swings.

Dynamic asset allocation strategies are often based on heavy quantitative analysis and usually the domain of professionals, since you need to be very vigilant in monitoring the portfolios. Depending on how strict your rules are for maintaining a particular target, you would need to rebalance more frequently.

As you get more and more dynamic, and shift those targets around according to predictions of the shape of future markets, you get into another variety of asset allocation called tactical asset allocation. This is a much more active strategy where the targets you use are updated as an investor’s beliefs about future performance change. This is not rebalancing; instead, it’s changing the allocations and then balancing into those new allocations. To continue with the shoe store analogy, if all of a sudden the neighborhood became popular with Dutch and Latvian immigrants, you might change your allocation of sizes to have way more large size shoes.

For all varieties of asset allocation, rebalancing is used to bridge the gap between  your actual asset allocation and your ideal targets, whatever they may be. Investors pursuing a more static approach need not perseverate too much over their targets and how close their portfolios are to those targets at any particular time. More aggressive portfolios may benefit from more frequent rebalancing, say once every three months, but in general, the conventional wisdom is that once a year is fine and every quarter can work too. As you get into more dynamic and tactical strategies, this rebalancing usually gets more frequent, another reason why these strategies are employed more by professionals and not so much with DIYers.

How Strategic Asset Allocation Helps Investors

For one, having a plan ahead of time for how much to allocate to stocks, to bonds, to whatever, helps investors avoid the pitfalls of chasing returns. If you just looked at what’s popular at any given moment, you’d wind up chasing the high profits of tech companies one year, crypto the next, and maybe oil futures the year after. This means that you’d be buying assets after they’d already been booming - a surefire way to buy high. You might then get frustrated with their lackluster subsequent performance and sell low, the exact opposite of good investing.

Strategic Asset Allocation, especially the static variety, solves that problem, by definition, as it forces the investor to buy more when prices are (relatively) down and sell when they are (relatively) high. It really can’t be simpler.

Having a strategic asset allocation has a positive mental component, as well. It helps the investor block out much of the investing noise on the day to day or week to week level and instead focus on long-term strategies. I, for one, have been so liberated by the fact that I never need to worry if now is the right time to sell X or buy Y. I have a spreadsheet that tracks performance and how far each asset is from its target, and it is always ready to spit out the exact action I should take. If my target is that stocks should be 50% of my portfolio, but I now see that I am at 48.58%, I automatically know what I need to invest in when I get my next paycheck. When I track my portfolio, I don’t even have the prices of individual assets on my screen. I know all I need just by tracking each asset’s proportion of the whole.

Next Steps

The natural next question is a doozy: Ok, then what is the best strategic asset allocation to have?

It’s a bit like the question “Which stocks should I buy?” in the sense that many people have a good guess, but it’s not really answerable. This whole blog, nay, this whole field of investing, is dedicated to this basic question, and while I have my opinions, only hindsight can be 20/20.

As each investor works towards their own answer to that question, the discussions of different asset classes and the test portfolios on this blog can help provide insight.