Having reviewed the attributes of each asset class, the next step is to construct your investment portfolio. There are a number of factors that will drive the composition of your portfolio, including the allocation to the different asset classes. The most important factors are your investment objectives, the time frame over which you want to meet your objectives and your risk profile. Other factors include the attributes of each asset class, the correlations between the different asset classes within your portfolio, the economic and stock market outlook and current valuations.
Before turning our attention to these factors, it is worth noting that the degree to which active allocation between asset classes contributes to portfolio returns has been the subject of great debate among academics and investment managers.
One of the most famous studies on asset allocation was entitled 'Determinants of Portfolio Performance' in 1995 by Gary Brinson, Randolph Hood and Gilbert Beebower. They studied the performance of 91 pension fund schemes over a 10-year period and calculated that asset class selection determined 94 percent of the variation in portfolio returns. They said four percent was due to stock selection and two percent was attributed to market timing.
There are two types of asset allocation - tactical and strategic. Tactical asset allocation is about the ability to add value to a portfolio through market timing. To do this successfully, you have to be able to predict those markets and asset classes that will perform well in the future, usually over the next six months to two years. This is notoriously difficult to do, so asset allocation should be primarily focused on achieving your lifetime objectives through strategic asset allocation, rather than trying to chase the top performing stock market or asset class. Strategic asset allocation involves making long-term weightings to asset classes to enable you to achieve your long-term financial objectives. Tactical asset allocation decisions can add to or detract from the long term strategic position.
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