What is Dynamic Asset Allocation?
Dynamic asset allocation is an investment strategy whereby an investor makes long-term investments in certain asset classes or securities and periodically buys and sells those securities in order to keep the allocations in their original proportions.
How Does Dynamic Asset Allocation Work?
Let’s assume you have $100,000 to invest. Based on your circumstances, risk aversion, goals and tax situation, you put $50,000 of the money in stocks, $30,000 in bonds, $10,000 in real estate, and $10,000 in cash. Thus, 50% of the portfolio is in stocks, 30% is in bonds, 10% is in real estate, and 10% is in cash. As time passes, the stocks in the portfolio might rise so much in value that the stock weighting increases from 50% to 70% and consequently reduces the proportion of the other asset classes in the portfolio.
In this situation, the investor might sell some of the stocks or purchase securities in other asset classes in order to bring the portfolio back to the original weighting. If the investor reweights the portfolio frequently, say every three months, then the investor is said to engage in market timing, tactical asset allocation, or active investing. In both types of rebalancing approaches, the investor must consider whether the effort and additional transaction costs will increase returns. However, if the investor refrains from rebalancing the portfolio at all, effectively leaving the investments to do what they may, the investor is practicing a true buy and hold strategy.
Why Does Dynamic Asset Allocation Matter?
Many experts believe that what an investor buys or sells is more important than when he or she buys or sells it. This is the essence of asset allocation. Because many asset classes tend to rise and fall together, a portfolio’s overall return is much more affected by how the portfolio is allocated rather than the specific securities chosen. A well-known 1986 study by Brinson, Hood and Beebower confirmed that 95% of the time, asset allocation determined a portfolio’s returns rather than the specific securities chosen.
A dynamic asset allocation strategy is a mix of active and passive investing. On one hand the investor keeps a consistent, long-term asset allocation and does not alter that based on short-term market swings or stock fads. On the other hand, the investor buys and sells securities in his portfolio occasionally in order to keep the portfolio aligned with the original weightings.
Dynamic asset allocation is often cheaper than active trading. It can have tax benefits if the IRS taxes long-term capital gains at a lower rate than short-term capital gains. Also, the strategy requires less in trading commissions and advisory fees, which often force investors to have higher return requirements to compensate for these extra costs.