Asset Allocation

Asset allocation has three components: Strategic Asset Allocation (SAA) sets the long-term target weights based on goals and risk tolerance. Tactical Asset Allocation (TAA) makes shorter-term deviations from the SAA based on valuation signals, economic cycle positioning, or momentum. Rebalancing brings the portfolio back to target weights when drift causes allocations to diverge from targets. The SAA is the foundation; TAA and rebalancing are tools to implement it efficiently over time.

Brinson, Hood, and Beebower's 1986 study (replicated in 1991) found that 91.5% of the variance in quarterly returns across pension funds was explained by asset allocation policy rather than security selection or market timing. This finding — though debated in its precise magnitude — establishes the core principle: getting the asset class mix right matters far more than picking the best stocks within each class. A high-equity allocation in a bull market will outperform a conservative allocation almost regardless of security selection within each class.

Equities offer the highest long-run expected return (roughly 6-8% real annually for US equities over century-long histories) at the cost of high short-term volatility (20-50% peak-to-trough drawdowns in bear markets). Fixed income provides lower expected returns (1-4% real) with lower volatility, and traditionally provides negative correlation to equities during risk-off events — the diversification benefit. Cash (money market funds, T-bills) offers near-zero real return but maximum liquidity and zero principal risk.

Real assets — real estate, commodities, TIPS (inflation-protected securities) — provide inflation hedging that stocks and nominal bonds don't. In inflationary environments (2021-2023), real assets dramatically outperformed both equities and nominal bonds. Alternative strategies (hedge funds, private equity, merger arbitrage) aim for equity-like returns with different correlation profiles. The diversification benefit of alternatives depends critically on whether their low correlation to public markets is genuine or reflects illiquidity and infrequent marking rather than true independence.

Risk-based allocation guidelines: 100% equities for 25-30 year horizons (time is the cushion against drawdowns), 70-80% equities for 10-15 year horizons, 50-60% equities for 5-10 year horizons, and increasingly conservative for shorter time horizons or high withdrawal needs. These guidelines are starting points — specific needs, liquidity requirements, income sources, and behavioral tolerance all modify the appropriate allocation. Target-date funds implement this logic automatically, gliding from equity-heavy to more conservative as the target date approaches.

Maintaining an allocation requires rebalancing as market movements cause drift. A portfolio that started 70/30 equity/bond after a prolonged bull market might drift to 85/15 — substantially riskier than intended. Calendar rebalancing (annually) or threshold rebalancing (when any allocation drifts more than 5 percentage points from target) both work. The evidence slightly favors threshold rebalancing for capturing momentum while still maintaining risk control, but the discipline to rebalance at all — particularly selling equities after a bull run — matters more than the specific method.