Dynamic asset allocation is a way to manage risk in your portfolio and generate above-market returns by moving with market trends. This type of approach combines elements of passive investing with active investing to help keep your portfolio balanced according to your risk tolerance and goals, while also keeping pace with the market. Dynamic asset allocation can be used to insulate your investments against stock market volatility and potentially maximize returns, but there are some drawbacks to keep in mind.
What Is Dynamic Asset Allocation?
Dynamic asset allocation means adjusting the mix of assets in a portfolio based on market trends. As the price of a stock of a price increases, you’d purchase additional shares to capitalize on future gains. If a stock or fund’s price is declining, on the other hand, you’d sell your shares to avoid losses.
In that sense, dynamic asset allocation is an investment strategy that centers on market timing. It’s less concerned with maintaining a specific mix of assets than maximizing return potential. Specifically, you wouldn’t be worried about whether you’re holding a 60/40 (stock/bond) split within your portfolio or having a certain asset mix. Instead, you’d be focused on how individual stocks or funds are moving up or down over time and how to best keep pace with that momentum.
Dynamic asset allocation is more often the domain of fund managers, rather than individual investors. For example, you might invest in a mutual fund that utilizes this strategy. The fund manager would study the market and its associated trends to decide which assets to hold on to, which ones to sell and which ones to buy to produce the best return possible for investors. The idea is that it’s more important to focus on having the right allocation of asset classes, rather than the underlying securities themselves.
Dynamic Asset Allocation vs. Other Allocation Methods
There are other allocation strategies you can use to manage investments in a portfolio that differ from dynamic allocation. With strategic allocation, for example, you’re typically buying and holding investments for the long term and rebalancing them periodically. You’re holding assets based on the returns they’ve historically produced and while you may buy or sell investments to rebalance, it’s more of a passive investment strategy.
Constant-weighting allocation is similar to strategic allocation, but the biggest difference is that you might rebalance more often to keep your target allocation in sight. So for example, if you start off with 60/40 split between stocks and bonds and that eventually shifts to 70/30, you’d sell off certain assets and buy others to get back in line with your original allocation.
With tactical allocation, the objective is making investment moves that are designed to produce maximum returns in the short term. Some approaches are complementary to one another while others are not. For example, a dynamic allocation strategy would be considered a competitor to a constant-weighting strategy since the approaches are very different.
Pros and Cons of Dynamic Asset Allocation
The primary motivator for using this approach is to generate returns above what the market as a whole is delivering. If you’re investing in a fund that has an experienced fund manager who understands the finer points of dynamic asset allocation, then those investments could prove more rewarding than ones that use strategic asset allocation. It’s effectively a way to capitalize on which way market trends are moving and benefit financially from a particular stock or fund’s forward momentum.
Diversification is another reason to consider dynamic asset allocation. Having a broader range of investments included in your portfolio could improve your overall return profile if some of those investments perform better than others. At the same time, you’re spreading out risk in case one of the investments underperforms or is naturally more sensitive to market volatility.
Where dynamic asset allocation can be a challenge is in the management of your portfolio’s underlying assets. This kind of strategy requires investors to be tuned in to market trends and changes in overall market conditions. If you don’t have time to closely monitor market trends and micromanage your portfolio, then you might be better off skipping a dynamic asset allocation approach or relying on an experienced fund manager to do it for you.
The other thing to keep in mind is cost. If you’re investing in actively managed funds that follow a dynamic approach, the assets in the fund may turn over more frequently than they would with an index fund or a passive ETF. That means the fund may trigger more taxable gains events, which are passed on to you as the investor. There are also the costs of trading stocks or funds yourself in an online brokerage account and paying trading or commission fees. Either way, higher costs can detract from the returns you’re seeing from your investments.
How to Invest Using a Dynamic Approach
If you’re interested in using dynamic asset allocation, there are a few rules to keep in mind.
First, set realistic expectations for what you hope to achieve with your investment choices. Specifically, you need to understand how different companies may perform in different market environments. A value stock that’s less sensitive to volatility may carry lower risk but you may not see the same level of returns as you would with a growth stock, for instance.
Next, consider how much risk you’re really comfortable taking on. Risk tolerance means how much risk you’re willing to accept, while risk capacity means how much risk you need to take to reach your investment goals. If dynamic asset allocation would require you to take on more risk than you typically do to meet your return expectations then you need to make sure you’re comfortable with that trade-off.
Finally, familiarize yourself with market cycles and how they work. You may also want to brush up on the basics of momentum investing and how different trends operate before you get too far along with making investment choices. Momentum investing involves buying and selling stocks that have been increasing or decreasing in price over a set time frame, typically three to six months.
The Bottom Line
Dynamic asset allocation is just one way to build a portfolio and potentially enjoy stronger returns. However, it’s not necessarily right for every investor. Having a clear understanding of what your goals are and how comfortable you are with risk can help you decide if it’s right for you.
Tips for Investing
- A financial advisor can help you decide whether a dynamic asset allocation approach is appropriate. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- Finding an asset allocation that fits your investor profile, whether that’s conservative or very aggressive or somewhere in between, can be challenging. Consider using the SmartAsset Asset Allocation Calculator to see whether your profile as an investor matches the securities you’ve bought.
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