InvestorWords.com defines asset allocation as the process of dividing investments among different kinds of assets, such as equities (read 'Shares: safe and sound'), bonds, real estate (read 'Property MythBusters') and cash, to optimise the risk/reward (click here to learn what risk is) trade-off based on an individual's specific situation and goals.

"It is a key concept in financial planning and money management," says Dr Prieur du Plessis, Plexus group chairman.

"There is no simple formula to find the right asset allocation for every individual," says Du Plessis. However, most financial professionals agree that asset allocation is one of the most important investment decisions.

Principal determinant of investment results

"Your selection of individual securities is secondary to the way you allocate your investment in equities, bonds, real estate and cash. The division among assets is the principal determinant of your investment results," says Du Plessis.

Modern Portfolio Theory is a theory about how risk-averse investors can construct portfolios to maximise expected returns based on a given level of market risk, emphasising that risk is an inherent part of higher reward. According to the theory, pioneered by Harry Markowitz, it is possible to construct an 'efficient frontier' of optimal portfolios offering the best possible expected return for a given level of risk.

Asset allocation funds attempt to provide investors with portfolio structures that address an investor's age, risk appetite and investment objectives with an appropriate or optimal apportionment of asset classes. At inception of the portfolio, a 'base policy mix', namely the long-term strategic asset allocation of the fund, is established based on expected returns.

Portfolio needs constant re-adjustment

"As the value of assets can change due to market conditions, the portfolio constantly needs to be re-adjusted back to the strategic asset allocation. This ensures that the risk and return profile of the fund remains the same," says Du Plessis.

According to Du Plessis, determining a strategic asset allocation for a portfolio is not as simple as it sounds, as expected returns cannot be based purely on long-term historic averages. Current valuations, the economic cycle and future prospects for the asset classes should also be taken into account.

"Perhaps tactical asset allocation is the most important factor in determining the success of an asset allocation fund," says Du Plessis. This strategy allows portfolio managers to create extra value by taking advantage of certain situations in the market place, such as pricing anomalies or expected strong outperformance from certain asset classes.

Overweight in those expected to outperform

"The manager will overweight the asset classes expected to outperform and underweight those expected to underperform. It is normally a moderately active strategy since managers return the portfolio to its original strategic asset mix when the desired short-term profits are achieved or the overweight asset class becomes overvalued," adds Du Plessis.

The most important question is how successful managers are at making tactical asset allocation decisions. Research conducted by Plexus Asset Management on the returns of various domestic asset allocation funds over one, five and 10 year periods ending 29 February 2009, which is close to the most recent market bottom, reveals some startling facts.

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