Asset Allocation is a strategy to invest in which investors or portfolio managers try to balance risks and rewards by making a suitable adjustment of the percentage of the amount which is invested in an asset or portfolio. This usually varies with the risk tolerance of the investor, his long-term goals and also time frame of the investor.
Asset allocation is useful because different financial assets vary in their returns as per the prevailing market conditions and other user requirements and not all are perfectly correlated with each other. It is thus useful to diversify across multiple sectors to bring down the overall risk of the portfolio. It is classified into three types:
- Strategic Asset Allocation: It stands for assigning weights to various classes of assets across the investment horizon. The portfolio return is thus weighted average return of various classes.
- Tactical Asset Allocation: It stands for deviations from ideal asset allocation in the short term done to capitalise on the market fluctuations or attractive investment opportunities which exist for small periods. The investors also become active after short-term profits.
- Dynamic Asset Allocation: This is basically for highly active investors who keep a constant check on their portfolios. These investors keep modifying their portfolios as a reaction to market fluctuations.