Strategic Asset Allocation (SAA)
__Strategic asset allocation__ (SAA) is a fancy finance term for "planned division of resources that have economic value." The planning being discussed here is long-term financial planning. In order for an investor to allocate assets, some homework must be done ahead of time. Investors need to identify key parameters for their future. They also make decisions on how much risk they are willing to assume. This information is collected and placed in the investment policy statement (IPS) and reviewed by a portfolio manager.
Suppose Bill is a 50-year-old, unmarried American man. He has one child who is already in college. Bill is an engineer with a stable employment history looking to retire in 5–10 years, and he does not have a pension program.
Besides knowing when Bill's cash flow from work may cease, what other key information would you think is necessary from him in order to prepare his strategic asset allocation?
Yes.
Bill's risk tolerance is vital to portfolio planning and establishment. Some people are extremely aggressive risk-takers and some are extremely conservative. Where Bill stands on what he is comfortable with risking to lose is the information that portfolio managers need to incorporate into the SAA.
No.
Bill's current location is irrelevant. What might be relevant as part of identifying long-term capital requirements or excess is whether or not Bill might be making a major investment by purchasing a retirement condo, or whether plans to sell his existing home, if he has one.
No.
When insurance companies provide life insurance, the health of the individual is considered, but this is not of concern in portfolio development. General life expectancy for males is considered when preparing Bill's portfolio, but his specific life span remains unknown.
Bill's portfolio manager must take the amount of assets that are available for investing and layer in the level of risk Bill can handle at this stage of his life. Maybe he was a thrill seeker as a child, but that may no longer be the case. Once he retires from his career, Bill needs to have a reliable income stream to enhance any social security benefits he may receive.
Bill has $375,000 of cash and money-market instruments. He likes football, and he invested an additional $25,000 in common stock in a professional football team.
Without establishing percentages yet, which asset class do you suppose a manager would recommend that Bill add?
Yes.
Bill has no fixed income such as corporate bonds, government bonds, or other securities that pay fixed monthly payments. Even though Bill should likely take fixed payments and use them to purchase additional securities in his portfolio, the capital market expectations for the bond asset class factor into Bill's risk tolerance profile.
No.
Bill has over 6% of his financial assets already in one stock, the football team corporation. For now, this asset class is already represented.
No.
Bill has a lot of cash and cash equivalents, and it doesn't make great sense to move from this asset class to real estate, where his investment may prove less liquid and which is impacted by the risks of inflation. Capital-market outlooks in real estate plus Bill's age make this not the best selection.
What do you think about this recommended SAA?
No.
The rule of 120 (stock allocation should be 120 minus your age) would have set the equity asset percentage to 70%, and this perhaps better reflects Bill's risk tolerance and expected long-term returns.
Yes.
This SAA should look a little different. The manager could use the rule of 120, which is for aggressive, healthy investors who have a great chance at living beyond the median, and who will retire around 60–65. Since stocks have shown to outperform bonds in the long-term horizon, Bill can afford to maintain a greater allocation towards stocks. Bill also doesn't need this much in cash/cash equivalents. It is prudent to keep 3–6 months' worth of expenses as liquid funds, but this level is overkill for Bill as he loses out on potential expected returns through other asset investments.
He should most likely have a SAA that is 70% equity, 25% bonds, 5% cash and hold this for 5 years. At 60 years old, he can revisit his allocations and revise his strategy based on new outlooks.
No.
Bill can easily afford to have more than 50% equity in his portfolio, but it should not all be with the football team. It is known that he is risk aggressive and that he is looking to retire soon. He will likely need more equity to achieve his long-term goals.
To summarize:
[[summary]]
So, Bill's portfolio manager has decided to convert some cash into fixed income to take advantage of hedging and diversification between asset classes. He looks and determines that Bill's risk tolerance is extremely high. This is good news because Bill's savings horizon is small compared to his draw horizon. Bill will benefit by collecting a paycheck as long as he can withstand the grind of being an engineer.
The portfolio manager puts together the following frame for the SAA. He considers market outlook and risk tolerance and decides to use the rule of 100, where he subtracts Bill's age from this to determine equity level. He then recommends that Bill carry 50% in equity as he thinks Bill will outlive the median age for men, which is 80 years. He thinks 30% should be in bond assets and the remaining 20% in cash/money-market instruments.
In line with risk considerations, investors can design SAAs with four basic objectives in mind: capital preservation, income, growth, and balance. Investors who seek capital preservation will need to use cash within a year as they do not wish to lose any principal value. These SAAs are heavily weighted with commercial paper, money-market funds, and cash. Investors who have income as their primary objective try to maintain a portfolio that generates income mainly through corporate fixed-asset securities, real estate investment trusts (REIT), and treasury notes.
What do you suppose is the biggest risk to those with capital preservation objectives?
No.
Credit risk is not a factor here because investors who are looking for capital preservation do not carry a large percentage of bonds in the portfolio. Credit risk is not the risk of using credit cards too much as an alternative to cash.
No.
Equity risk does not contribute much risk to an SAA with capital preservation objectives. Equity is a very small percentage of the asset-class mix.
Yes.
Capital preservation-balanced SAA can contain 75% or more of cash and cash equivalent assets, all of which have extremely low returns on investment. It is possible that if the capital is not needed in such a short time frame, the investor could lose out due to erosion of the purchasing power of the assets by inflation.
If an investor's objective is growth, the SAA can be designed to build long-term wealth. Unlike the income objective SAA, an investor will likely increase his or her financial position by depositing additional funds.
An SAA can provide a compromise between growth and income objectives. This is called SAA with balanced objectives. The plan consists of placing assets in the portfolio that will generate cash and provide capital appreciation over the long term.
Who do you suppose would most benefit a growth-style SAA?
Yes.
A single, early-20s woman, or man, could best benefit from an SAA that is based on growth. Such a person will likely have a career and can contribute funds each year to help further grow the portfolio.
No.
This individual would most likely need to have an additional source of income and would best be matched with an SAA with income objectives in mind.
No.
This individual would need cash resources available to execute the deal in the short term, which would be best achieved with capital-preservation SAA.
Where Bill lives
What Bill's risk tolerance is
What Bill's lifespan is
Real estate
Equity
Fixed income
It is unreasonable because the portfolio manager really used the rule of 120 to determine Bill's strategic equity level
It is unreasonable because Bill will not need this much in cash/cash reserves and he is risk aggressive
It is reasonable because Bill shouldn't hold more than 50% equity
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Credit risk
Equity risk
Inflation risk
A single woman in her early 20s
A single father with small children
A man who is trying to acquire a business
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