Asset allocation is the process by which one decides how to distribute resources among various possible investments. The main categories of investments within which this choice is oriented can be divided into financial assets (shares, bonds, liquidity) or real assets (real estate, commodities, precious metals, etc.).
The various investments or assets managed by the investor through asset allocation are generally divided and organized by types called asset classes. The asset classes can distinguish the nature of the investment: for example, debt securities such as bonds can constitute an asset class other than equity securities such as shares. However, the asset class organization system can also follow other methods: for example, the assets managed can be distinguished on the basis of the time horizon (short / medium / long term) within which the investment itself is framed.
In general, the asset allocation leads to the management and organization of the various assets and their sets divided by type (the asset class in fact) in a portfolio managed by the asset manager, i.e. by the one who decides alone or within the scope of a team how to allocate resources. In most cases, asset allocation is an activity carried out by professional and / or institutional investors such as asset management companies on behalf of their clients.
In essence, asset allocation has the task of achieving optimal portfolio management, that is, a management that balances the return and risk of the assets in the best possible way with the investor’s needs and expectations. The two instances of return and risk tend to be proportional as generally a high-risk activity also tends to have a high expected return. For this reason, risk is considered as one of the fundamental parameters to distinguish investments from one another. Some scholars speak in this regard of specific risk and generic risk.
- Specific risk is a risk linked to the nature of the investment itself. For example, if you take an equity investment, the specific risk will be given by the economic characteristics of the issuing company, the performance of the income statement, the equity solidity, the future prospects, the positioning of the company compared to its competitors;
- Generic (or systemic) risk, on the other hand, is the risk to which the individual investment is subjected due to market fluctuations and which cannot be eliminated or substantially reduced by diversifying the portfolio, as is the case for generic risk.
Asset allocation in general is divided into three further categories or be oriented according to three different approaches. In this sense, we commonly speak of strategic, tactical or dynamic asset allocation.
- Strategic asset allocation guides investments by choosing to organize them according to a medium and long-term time horizon;
- Tactical asset allocation: it is instead an allocation based on a short-term horizon and therefore based on a contingent market vision compared to the strategic one. Generally this type of asset allocation is used to adapt the strategic allocation to specific and temporary market trends, however a certain consistency between these two types of asset allocation generally allows to avoid errors in portfolio management;
- Finally, dynamic asset allocation represents a kind of investment allocation that is even more oriented towards a reading of the market under the short-term time perspective. Dynamic asset allocation is often referred to to explain rapid portfolio adjustments to abrupt changes in the market; however, it should be emphasized that the time factor (timing) is in general a very important element for asset allocation which is generally considered a dynamic process.
Obviously, there are very different investor profiles that require the same number of management of individual portfolios. For example, an investor with a low risk / return profile will tend to be more oriented towards a financial portfolio with a higher bond than equity component.