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- Portfolio Insurance – Dynamic Asset Allocation Strategy
Portfolio Insurance – Dynamic Asset Allocation Strategy
- By Super Admin
- Published 17 March 2007
- Report, Assignment, Case Study and Term Paper
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Management of Equity Risk
Management of equity risk refers to either eliminate or reduce the risk associated with equity securities through the use of derivatives and dynamic asset allocation. Equity risk refers to variation in the value of individual shares of that of an equity portfolio. Equity risk essentially a ‘price risk’.
Asset Allocation Strategies
Establishing an appropriate asset mix is a dynamic process that may be the most important determinant of your portfolio's overall risk and return. Your portfolio's asset mix should reflect your goals at any point in time. There are a few different strategies of establishing asset allocations, and here we outline some of them and examine their basic management approaches.
Strategic asset allocation is a method that establishes and adheres to what is called a "base policy mix." This is a proportional mix of assets based on expected rates of return for each asset class. For example, if stocks have historically returned 10% per annum and bonds have returned 5% per annum, a mix of 50% stocks and 50% bonds would be expected to return 7.5% per year.
Strategic asset allocation generally implies a buy-and-hold strategy, even as the inevitable shifting values of assets will result in a drift from the initially established policy mix. For this reason, investors may choose to adopt a constant-weighting approach to asset allocation, in which the portfolio is continually re-balanced. For example, if one asset were declining in asset value, investors would purchase more of that asset class due to its "cheap" status, and if that asset value should increase in value it would be sold because it has become "expensive." There are no hard-and-fast rules for the timing of portfolio re-balancing under strategic or constant-weighting asset allocation. However, a common rule-of-thumb is that the portfolio should be re-balanced to its original mix when any given asset class moves more than 5% from its original value.
Over the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore, the investor may find it necessary to occasionally engage in short-term, tactical deviations from the mix in order to capitalize on unusual or exceptional investment opportunities. This flexibility adds a component of market timing to the portfolio, allowing investors to participate in economic conditions that are more favorable for the performance of one asset class than for others.
Tactical asset allocation can be described as a moderately active strategy, since the overall strategic asset mix is returned to when desired short-term profits are achieved. This strategy demands some discipline from the investor or portfolio manager, as he or she must first be able to recognize when short-term opportunities have run their course, and then re-balance the portfolio to the long-term asset position.
Another active asset allocation strategy is dynamic asset allocation, in which the mix of assets is constantly adjusted as markets rise and fall and the economy strengthens and weakens. Because it sells assets that are declining in value and purchases assets that are increasing in value, the dynamic asset allocation is the polar opposite of a constant-weighting strategy. For example, in a dynamic portfolio, if the stock market is showing weakness, stocks are sold in anticipation of further decreases in stock values, and if the market is strong, stocks are purchased in anticipation of continued market gains.
Under an insured asset allocation strategy, a base portfolio value is established under which the portfolio should not be allowed to drop. As long as the portfolio achieves a return above its base, active management is exercised to try to increase the portfolio value as much as possible. If, however, the portfolio should ever drop to the base value, all assets are invested in risk-free assets so that the base value becomes fixed. At such time, the investor would consult with his or her advisor on re-allocating assets, perhaps changing his or her investment strategy entirely. An insured asset allocation strategy can be implemented by way of a formula approach or a portfolio insurance approach. The formula approach is a graduated strategy: as the portfolio value decreases, more and more risk-free assets are purchased so that when the portfolio reaches its base level it is entirely invested in risk-free assets. The portfolio insurance approach uses put options and/or futures contracts to preserve the base capital. Both approaches are considered active management strategies, but when the base amount is reached, a passive approach is adopted.
Insured asset allocation would be suitable to risk-averse investors who desire a certain level of active portfolio management but appreciate the security of establishing a guaranteed floor below which the portfolio is not allowed to decline. For example, an investor who wishes to establish a minimum standard of living during retirement might find an insured asset allocation strategy ideally suited to his or her management goals.
Integrated asset allocation ensures that both economic expectations and client risk are considered in establishing an asset mix. While all of the above-mentioned strategies for asset allocation take into account expectations for future capital market returns, not all of the strategies account for investment risk tolerance. Therefore, integrated asset allocation includes aspects of all strategies, accounting not only for expectations but also actual changes in capital markets and the investor's risk tolerance. Integrated asset allocation is a broader asset allocation strategy, albeit one allowing for only one of dynamic or constant-weighting allocation--obviously, an investor would not wish to implement the aspects of two strategies that are competing with one another.
Asset allocation can be an active process in varying degrees or strictly passive in nature. Whether an investor chooses a precise asset allocation strategy or a combination of different strategies depends on that investor's goals, age, and risk tolerance. Keep in mind, however, that this article gives only general guidelines on how investors may use asset allocation as a part of their core strategies. Be aware that allocation approaches that involve anticipating and reacting to market movements require a great deal of expertise and talent in using particular tools for timing these movements. Some would say that accurately timing the market is next to impossible, so make sure your strategy isn't too vulnerable to unforeseeable errors.
Management of equity risk refers to either eliminate or reduce the risk associated with equity securities through the use of derivatives and dynamic asset allocation. Equity risk refers to variation in the value of individual shares of that of an equity portfolio. Equity risk essentially a ‘price risk’.
Asset Allocation Strategies
Establishing an appropriate asset mix is a dynamic process that may be the most important determinant of your portfolio's overall risk and return. Your portfolio's asset mix should reflect your goals at any point in time. There are a few different strategies of establishing asset allocations, and here we outline some of them and examine their basic management approaches.
Strategic asset allocation is a method that establishes and adheres to what is called a "base policy mix." This is a proportional mix of assets based on expected rates of return for each asset class. For example, if stocks have historically returned 10% per annum and bonds have returned 5% per annum, a mix of 50% stocks and 50% bonds would be expected to return 7.5% per year.
Strategic asset allocation generally implies a buy-and-hold strategy, even as the inevitable shifting values of assets will result in a drift from the initially established policy mix. For this reason, investors may choose to adopt a constant-weighting approach to asset allocation, in which the portfolio is continually re-balanced. For example, if one asset were declining in asset value, investors would purchase more of that asset class due to its "cheap" status, and if that asset value should increase in value it would be sold because it has become "expensive." There are no hard-and-fast rules for the timing of portfolio re-balancing under strategic or constant-weighting asset allocation. However, a common rule-of-thumb is that the portfolio should be re-balanced to its original mix when any given asset class moves more than 5% from its original value.
Over the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore, the investor may find it necessary to occasionally engage in short-term, tactical deviations from the mix in order to capitalize on unusual or exceptional investment opportunities. This flexibility adds a component of market timing to the portfolio, allowing investors to participate in economic conditions that are more favorable for the performance of one asset class than for others.
Tactical asset allocation can be described as a moderately active strategy, since the overall strategic asset mix is returned to when desired short-term profits are achieved. This strategy demands some discipline from the investor or portfolio manager, as he or she must first be able to recognize when short-term opportunities have run their course, and then re-balance the portfolio to the long-term asset position.
Another active asset allocation strategy is dynamic asset allocation, in which the mix of assets is constantly adjusted as markets rise and fall and the economy strengthens and weakens. Because it sells assets that are declining in value and purchases assets that are increasing in value, the dynamic asset allocation is the polar opposite of a constant-weighting strategy. For example, in a dynamic portfolio, if the stock market is showing weakness, stocks are sold in anticipation of further decreases in stock values, and if the market is strong, stocks are purchased in anticipation of continued market gains.
Under an insured asset allocation strategy, a base portfolio value is established under which the portfolio should not be allowed to drop. As long as the portfolio achieves a return above its base, active management is exercised to try to increase the portfolio value as much as possible. If, however, the portfolio should ever drop to the base value, all assets are invested in risk-free assets so that the base value becomes fixed. At such time, the investor would consult with his or her advisor on re-allocating assets, perhaps changing his or her investment strategy entirely. An insured asset allocation strategy can be implemented by way of a formula approach or a portfolio insurance approach. The formula approach is a graduated strategy: as the portfolio value decreases, more and more risk-free assets are purchased so that when the portfolio reaches its base level it is entirely invested in risk-free assets. The portfolio insurance approach uses put options and/or futures contracts to preserve the base capital. Both approaches are considered active management strategies, but when the base amount is reached, a passive approach is adopted.
Insured asset allocation would be suitable to risk-averse investors who desire a certain level of active portfolio management but appreciate the security of establishing a guaranteed floor below which the portfolio is not allowed to decline. For example, an investor who wishes to establish a minimum standard of living during retirement might find an insured asset allocation strategy ideally suited to his or her management goals.
Integrated asset allocation ensures that both economic expectations and client risk are considered in establishing an asset mix. While all of the above-mentioned strategies for asset allocation take into account expectations for future capital market returns, not all of the strategies account for investment risk tolerance. Therefore, integrated asset allocation includes aspects of all strategies, accounting not only for expectations but also actual changes in capital markets and the investor's risk tolerance. Integrated asset allocation is a broader asset allocation strategy, albeit one allowing for only one of dynamic or constant-weighting allocation--obviously, an investor would not wish to implement the aspects of two strategies that are competing with one another.
Asset allocation can be an active process in varying degrees or strictly passive in nature. Whether an investor chooses a precise asset allocation strategy or a combination of different strategies depends on that investor's goals, age, and risk tolerance. Keep in mind, however, that this article gives only general guidelines on how investors may use asset allocation as a part of their core strategies. Be aware that allocation approaches that involve anticipating and reacting to market movements require a great deal of expertise and talent in using particular tools for timing these movements. Some would say that accurately timing the market is next to impossible, so make sure your strategy isn't too vulnerable to unforeseeable errors.
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Article Series
This article is part 1 of a 7 part series. Other articles in this series are shown below:
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Portfolio Insurance – Dynamic Asset Allocation Strategy