The theory and practice of diversifying the investments of a portfolio between different asset classes, e.g., equities, bonds, cash, alternatives. Conventional portfolio theory states that a portfolio diversified across relatively uncorrelated assets will achieve higher returns with lower risk than a less diversified portfolio.
The optimal asset allocation in the short and long-term will not necessarily be the same. Strategic asset allocation involves periodically rebalancing the portfolio in accordance with the investor’s long- term goals for asset allocation. It involves a historical analysis of the trends in financial assets and their correlations, to assess the investor’s optimal exposure to each asset class based on the economic environment at the time.
Tactical asset allocation is the active management of an investment portfolio in order to take advantage of short-term opportunities in the market. It involves analysing the present conditions, together with likely short-term economic, political, and financial trends, and selecting short-term investment options. It has the two-fold objective of taking advantage of market opportunities while avoiding an increase in portfolio risk
Thus the first step in the portfolio management process is to identify an investor’s time horizon and personal financial objectives. The investor’s asset allocation is carried out accordingly. Finally, the portfolio manager attempts to identify opportunities in the market to generate favourable risk-adjusted returns.