Asset Allocation: Strategic Investing : Active Asset Allocation

The excess return of equity over debt is called the equity risk premium. It is the reward for taking on the uncertainty of shareholding – its high potential for significant capital gain or loss.

The premium - the extra return - varies over time.

An active asset allocation strategy attempts to take advantage of these changes in the equity risk premium - responding tactically to changing market conditions.

Why does the equity risk premium change?

The size of the equity risk premium essentially depends on the expected direction of interest rates -which are themselves driven by expected inflation rates.

Debt instruments are more sensitive to interest rate changes than equity. So although company profitability (and hence share returns) is adversely affected by increasing interest rates (which make company and consumer borrowing more expensive, so slowing down economic activity), it is not as badly affected as debt.

The fixed income from bonds is their main source of investment value, so they are highly sensitive to changes in interest rates. When interest rates are rising in response to inflation fears, the fixed income on bonds becomes less valuable so their real returns drop significantly.

The price of money market instruments is less affected by investors making profit or loss calculations based on expected inflation/interest rates because of the short term nature of the investment. Because of their short lifespan, their rates of return tend to track current floating rates - so money market instruments are, to a large extent, immunised against interest rate risk.

What this all means is that if an inflationary period is anticipated there should be greater emphasis on equities and money market instruments; and if a deflationary period is anticipated, then bonds become more attractive investments.

Conclusion

The asset allocation process need not be purely a fixed process - matching holding period and risk appetite to a suitable mix of asset classes. It can also be an active process in which the asset mix is adjusted in response to changing levels of relative return between asset classes; which are in turn created by changing levels of economic activity and shifts in interest rates.