An asset class is a group of securities that exhibit similar characteristics and behave similarly in the marketplace (risk-return relationship). Examples of asset classes are money market funds, fixed-income (bonds), equities (stocks), real estate, natural resources, precious metals, collectibles and insurance products. We can even further break down equity investments into additional sub-classes, such as large-cap, mid-cap and small-cap equities.

Asset classes are the building blocks of asset allocation, which is the process of choosing among various kinds of possible asset classes. Empirical studies have shown that 85-95% of a portfolio's total returns come from the asset allocation policy decision, not the selection of specific stocks and bonds. Asset allocation determines what percentage of your total portfolio you devote to the numerous asset classes available.

A strategic asset allocation (SAA) involves an examination of capital markets, to gauge future investment returns, combined with an understanding of portfolio objectives, risk tolerance, and constraints, to distribute a portfolio's assets effectively and efficiently among several asset classes in order to achieve the best return possible within acceptable risk levels.

SAA involves:

• Capital market expectations. The key to any sound asset allocation decision is determining which asset class is expected to outperform others in the short, medium, and long terms and then positioning your portfolio appropriately by shifting more of your assets into the soon-to-be-outperforming asset class at the right time. For example, if the stock market is expected to outperform the bond market, you should have more of your portfolio dedicated to stocks. If the stock market is expected to be weak, add more bonds to your portfolio.

• Choosing eligible asset classes based on objective, risk tolerance, constraints, and capital market assumptions.

• Finding percentage allocations to each asset class (using optimization/simulation techniques). The best way to match expected returns and client objectives is to determine the efficient frontier for the client.
• Selecting benchmarks that reflect the expected performance of each asset class.

Steps toward an Actual Portfolio

Risk budgeting is a process by which investment managers determine how much risks should be taken and how risk can be most effectively allocated across different asset classes.

In addition to taking systematic risks, an investment committee may choose to take tactical asset allocation risks or security selection risks. The amount of return attributable to these decisions can be measured.

• Although all asset allocation strategies, by definition, involve regularly readjusting the asset mix of a portfolio, tactical asset allocation is an active portfolio management strategy that seeks to improve portfolio value by utilizing short-term asset class weightings that differ from the long-run asset mix. Since it is tactical in nature, it requires short-term deviations from the policy asset allocation and focuses on improving return at some expense to risk management.

• Security selection is an attempt to generate higher returns than the asset class benchmark by selecting securities with a higher expected return.

As time goes on, a client's asset allocation will drift from the target allocation; the amount of allowable drift as well as a rebalancing policy should be formalized.