Types of Asset Allocation

Asset allocation refers to the percentages of investment capital put into the various types of investments. The goal with asset allocation is to achieve maximum return within an acceptable amount of risk.

There are four major types of asset allocation: Constant weight asset allocation, strategic asset allocation, dynamic asset allocation, and tactical asset allocation.

In this post, I’ll review these different types of asset allocation in relation to financial advisors, funds, and individual investors since the various models can be implemented by all three. If you’re an individual investor, this information will inform you about the investment strategies that you can use, as well as the strategies you might find if and when you’re looking to hire a financial advisor.

It is important to understand the 4 different types of asset allocation so you can choose the best approach for you to achieve your own financial goals. During over 40 years of investing my own money, I have used all four asset allocation methods but primarily use tactical asset allocations instead of the buy and hold investing method I used when I was much younger.

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Constant Weight Asset Allocation

Constant weight asset allocation is the most common type of asset allocation. This method holds a fixed percentage in different types of investments based on various asset allocation factors. This type of asset allocation disregards economic and market conditions in making investment decisions.

An example of constant weight asset allocation might be as follows:

Stocks 60%
Bonds 40%

With constant weight asset allocation, portfolio holdings must be adjusted to bring the portfolio back to the desired percentages since asset values are constantly changing, with the exception of cash and money market accounts. This portfolio adjustment is referred to as rebalancing and it is typically done annually, although a fewer number of investors rebalance more frequently such as biannually.

A constant weight asset allocation portfolio might end the year, for example, with the following allocation following a strong rise in stocks:

Stocks 70%
Bonds 30%

In this case, the investor would sell some of his stock holdings and buy bond holdings to bring the portfolio back to the original desired asset allocation. The main attribute of this type of asset allocation is that the intended allocation remains the same from year to year.

Of course, major life events such as retirement can call for a change in asset allocation. With a constant weight asset allocation, however, the change is due to the investor, not macro (large) economic or financial changes.

This type of asset allocation is often associated with the terms

Passive investing
Riding out the bear market
Buy and hold investing
Fixed asset allocation
Static asset allocation

Investors attempt to “ride out bear markets” with this type of asset allocation, and they often do if emotional investing doesn’t interfere.

There are pros and cons of asset allocation using a constant weight method. Most investors use constant weight asset allocation due to its simplicity and low cost yet wealth building opportunities from economic changes or long term market cycles are missed entirely with this type of asset allocation.

Strategic Asset Allocation

This type of asset allocation uses various asset classes to accomplish portfolio goals while managing risk. The classic example of this is adding U.S. Treasury bonds to a stock portfolio since bonds are an asset that goes up when stocks go down, at least some of the time. (Note: stocks and bonds were correlated more often than not in the decades prior to the 1990’s as explained in my video When Stocks and Bonds Fall Together.)

Asset classes that move in the opposite direction of one another are called noncorrelated. This noncorrelation between the two assets decreases portfolio risk. This principle is at the core of strategic asset allocation.

Other defensive investments besides bonds, such as gold or inflation protected bonds, are also used at times for risk management in many strategic portfolios.

Constant weight asset allocation is often used for strategic asset allocation and vice versa. These two types of asset allocation overlap but refer to slightly different objectives. The objective of constant weight asset allocation is to strongly adhere to a rigid allocation meant to keep an investor within defined risk parameters while reaching the desired goal while the structure of a strategic asset allocation should provide the framework to do so.

Asset class valuations and economic trends are disregarded with strategic asset allocation. Instead, this model focuses on how investments have moved relative to one another in the past.

Type of Asset Allocation	Main Attribute	Usage	Considers Asset Valuations or Economy	Tax	Pro	Con
Constant Weighted Asset Allocation	Rigid Allocation	Very Common	No	Favorable	Easy to Implement	Limited Upside
Strategic Asset Allocation	Correlation of Asset Price Movement	Very Common	No	Favorable	Easy to Implement	Limited Upside
Dynamic Asset Allocation	Changes Due to Macro Factors	Somewhat Common	Yes	Not as Favorable	Can Capture Opportunities	Hard to Beat Benchmarks
Tactical Asset Allocation	Seeks to Capitalize on Opportunities	Least Common	Yes	Least Favorable	Expert Models Available	Hard to Beat Benchmarks (Unless Model Used)
RetireCertain.com

Asset Allocation Strategies By Age

Some consider asset allocation strategies by age another type of asset allocation but they are really a strategic asset allocation that is adjusted very occasionally based on the investor’s age.

It is presumed investors should have more risk when younger, and thus hold a large percentage of net worth in stocks. On the other hand, it is presumed investors should have less risk near retirement, and hold a smaller percentage of stocks and a larger percentage of bonds.

Dynamic Asset Allocation

Changes are made to an asset allocation based on changes in the economy or the markets when using dynamic asset allocation.

While constant weight asset allocation rarely has asset class percentage changes, dynamic asset allocation has more frequent changes that are made when deemed necessary by the investor or financial advisor managing the portfolio.

Dynamic asset allocation is practiced by advanced investors, financial advisors, hedge funds, fund managers, and financial institutions.

Does Dynamic Asset Allocation Work?

It can be difficult to decide when to make asset allocation changes that will result in returns that beat passive investing models using a constant weight asset allocation.

With dynamic portfolio moves, there is also pressure for financial advisors or fund managers to outperform a passive constant weight asset allocation portfolio since wealth management fees can be high for active management. Asset allocation changes can trigger taxes, too.

Skilled investors and financial advisors, however, can enhance portfolio returns and/or lower stock market risk with dynamic asset allocation.

Carefully reviewing past performance for any fund using a dynamic asset allocation model will reveal the past success of the fund manager’s decisions. Individual investors can evaluate their own past investment decisions for what has and has not worked if they are using this active type of asset allocation.

Example of Dynamic Asset Allocation

What would trigger a move in a dynamic asset allocation portfolio or fund?

A fund manager following a dynamic asset allocation method may, for example, notice an unusually high risk level in the stock market. Noticing this, she may increase the fund’s allocation into Treasury bonds from 20% to 40%.

Alternatively, the fund manager may increase an allocation from the U.S. stock market to emerging stock markets based on a global growth trend.

With dynamic asset allocation, asset valuations, and economic conditions are carefully evaluated with the goal of getting the best return within the specified risk parameters.

Dynamic Asset Allocation Funds

A quick Google search will reveal that many financial firms offer dynamic asset allocation funds. Such a fund is often called “actively managed” since the manager must make asset allocation decisions based on changing conditions.

Macro global change or disruptive technology may trigger dynamic asset allocation changes, for example.

Advanced investors can also, of course, implement dynamic asset allocation strategies themselves rather than buy a fund that uses dynamic asset allocation.

After my own online search for dynamic asset allocation funds, I investigated Putnam Dynamic Asset Allocation Growth Fund (PAEAX).

The results on the company website for this fund are in the image below. Note the top blue arrow is for the Russell 3000 Index, which Putnam is using for the benchmark or comparison index. Notice that while the ride looks much smoother for investors in the Dynamic Asset Allocation Growth Fund, the performance is significantly below the performance of the Russell 3000 index.

Source: https://www.putnam.com/individual/mutual-funds/funds/8-dynamic-asset-allocation-growth-fund/A

Tactical Asset Allocation

Another type of asset allocation is tactical asset allocation. This active approach takes advantage of potential opportunities due to changing pricing and valuations. The main difference between a strategic vs tactical asset allocation is that the asset allocation percentages change based on perceived risks and opportunities instead of staying the same no matter what opportunities present themselves.

For example, a 55 year old investor may move to a higher portfolio cash allocation of 60% to lower stock market risk when market valuations become high based on historical levels. She may normally allocate only 55% of her retirement account to stocks given the short time frame before her retirement. After a major bear market, however, she may increase her stock allocation to 75% given that bear markets eventually allow investors to buy stocks at low stock valuations.

Once stocks return to more normal valuations, she may return to a 55% allocation to stocks or pursue another asset class based on valuations and expected returns.

All of these portfolio allocation changes are tactical in nature.

Like dynamic asset allocation, tactical asset allocation is done by advanced investors, financial advisors, and various types of funds.

Tactical Asset Allocation Models

Tactical asset allocation may be flexible and based on observation of opportunities and risks, or it may be practiced based on a defined model.

For example, tactical asset allocation changes may be as simple as the one used by the astute stock investor above who wishes to invest a higher allocation in stocks due to lower than normal valuations, or they may be more structured.

For example, tactical asset allocation models have been developed by expert investors, researchers, and quantitative analysts based on various factors such as pricing patterns and price movements among asset classes.

One huge benefit of a tactical model vs flexible implementation is that ETFs are often used for tactical asset allocation models so such models can be back tested to analyze past performance results. This can be particularly useful when comparing the model history to the current economic climate and financial markets.

The goals of tactical asset allocation models can be based on better risk management through lower portfolio volatility, higher than benchmark (index) returns, or both.

Tactical Asset Allocation Example

Meb Faber, as seen in my Best Advanced Investing Books post, authored a popular book on strategic asset allocation, The Ivy Portfolio. Meb has also been a pioneer in tactical asset allocation models, however. Results from 1973 through early 2022 for Faber’s EXD5 Tactical Asset Allocation model can be seen below.

Notice from the table below that the return (CAGR, Compounded Annual Growth Rate) isn’t as high as the S&P 500, but there was much less volatility with the tactical asset allocation because it moved out of stocks during long bear markets. The drawdown with this Faber tactical asset allocation model was -12.87% over 27.1 months while the S&P 500 drawdown was -55.25% over a lengthy 73.5 months for the same time frame.

This particular tactical asset allocation invests in various asset classes, including bonds. Therefore, the portfolio may well have beaten a fixed asset allocation portfolio with a blend of stocks and bonds, which would have been a more appropriate comparison to Faber’s model than simply the S&P 500 index.

One of my very favorite investing tools is Allocate Smartly because it allows individual investors to analyze, select and implement professionally developed tactical asset allocation strategies.

Tactical Asset Allocation Funds

Again, an online search will reveal there are tactical asset allocation funds as well as tactical asset allocation models that are used by both financial advisors and individual investors.

Tactical asset allocation covers a diverse collection of investment products and methods.

For example, both institutional and retail mutual funds may use tactical asset allocation that is based on a manager or other expert’s discretion.

For example, the firm Commonfund provides investment services to institutional investors. They define tactical asset allocation as “intentional market timing”. The tactical asset allocation factors they consider include:

Global Growth
Monetary Policy
Yield Curve
Equity Risk
Leading Economic Indicators
Employment
Inflation

Other tactical asset allocation models, such as the Faber model referenced in this post, are based on simple technical indicators instead of judgment about economic factors.

What Type of Asset Allocation Is Best?

Remember, dynamic and tactical asset allocation models are associated with active vs passive investing since decisions are made to change the asset allocation based on economic or other reasons.

Over the years, studies have repeatedly revealed that the overwhelming majority of active (aka tactical) fund managers underperform passive fund managers. According to CNBC, only 11% of large cap funds with active management performed better than passively managed funds over a 10 year period based on a Morningstar report.

Tactical mutual funds evaluated in another Morningstar report entitled Mind the Gap did not outperform a more traditional passive buy and hold asset allocation over a 10 year period ending March 2018…

…“the average tactical fund’s asset-weighted investor return lagged its total return by 1.96 percentage points annually…The average return gap across all U.S. funds measured 1.37 percentage points over the same 10-year period.”

Morningstar also reported that downside risk was not better with tactical funds, either, based on the study.

“During the 15 years through December 2018, the average fund in the tactical-allocation category tended to lose 5% more than Vanguard Balanced Index in months that the Vanguard fund posted negative returns.”

Return and drawdown data such as that seen for the Faber tactical asset allocation referenced elsewhere in this post reveal a lower return for tactical asset allocation than the S&P 500, but the drawdown was dramatically better and shorter by a large enough margin to be a good tradeoff for most risk-averse investors.

On the other hand, data from Allocate Smartly clearly reveals tactical asset allocation models that outperform passive index portfolios with better drawdowns.

The answer to whether tactical asset allocation works is that it depends on the strategy or method of tactical asset allocation being used more so than the type of asset allocation.

Tactical asset allocation implemented with the macro factors used by Commonfund simply doesn’t compare to a quantitative tactical asset allocation based on technical indicators. Even though they are both referred to as tactical asset allocation strategies, they are two entirely different constructs. The commonality is that neither uses a rigid asset allocation.

The conclusion based on my own research and investing is that tactical asset allocation does occasionally best passive investing, at least for some models.

Tactical Allocation ETF

In addition to managed tactical asset allocation funds, many ETFs exist that follow a tactical asset allocation model.

According to ETF.com, the total assets under management in tactical ETFs is $2.86 billion.

What Type of Asset Allocation Do Financial Advisors Use?

Financial advisors vary in the type of asset allocation they use. Many financial advisors like to adhere to a constant weight asset allocation while others prefer to make changes to the portfolio.

The asset allocation model used is often influenced by whether or not an advisor is affiliated with an investment firm and the policy of the firm.

The Best Type of Asset Allocation for You

My observation is that most investors are happy with a simple constant weighted portfolio during years of economic expansion and accompanying bull markets due to the high allocation in stocks that most asset allocations have. After a secular bear market, however, investors often prefer an asset allocation that considers market valuations and economic conditions.

Only you can decide the best type of asset allocation for you based on your own investing style, desired return, and risk tolerance.

A personal wealth plan will help you clarify these factors and choose wisely.