Strategic Risk Management: A Practical Guide to Portfolio Risk Management

CHAPTER 5

Strategic Asset Allocation

Strategic asset allocation is the principal determinant of long-term portfolio performance. It lies at the heart of the investment strategy of most institutional investors, such as endowments and pension funds. The practice is also becoming more widely used for private client portfolios and retail investors.

Strategic asset allocation specifies a static mix of asset classes that is intended to be a long-term plan for an investor. It is based on long-run relationships among asset class returns and the behavior of the investor's liabilities.

In their landmark paper, Brinson, Hood, and Beebower (1986) captured the importance of asset allocation policy, concluding that a static strategic asset allocation explained more than 90 percent of the variation of a fund's total return. Active investment decisions—security selection and market timing—were of less significance.

The importance of strategic asset allocation is also underscored by its role as a behavioral discipline. It provides an anchor against the temptation to follow short-term trends in market returns, which may harm the portfolio's long-term desired risk and return characteristics.

In this chapter, we discuss the theories behind strategic asset allocation, pitfalls, and practical approaches to successfully conducting and establishing a suitable strategic asset allocation.

GUIDING PRINCIPLES

Harry Markowitz is the founder of modern asset allocation principles. His work on portfolio theory—motivated ...