Asset allocation is a significant step in your portfolio management process. The initial step for the Portfolio Manager is to determine your required rate of return (7.5% in case of IPP as per assumptions). To achieve this we first must put in mind the protection of the principal. Our second goal is then to achieve the target rate of return. Implementing pre-determined asset allocation is a must to achieve required diversification (each asset class has a different risk and return characteristic). While most investors do understand this concept, they would still focus on which investment would outperform or whether equity markets would trend up or down. Although these are important considerations, many professional money managers believe that asset allocation is the most important decision for the Portfolio Managers.
Traditionally asset allocation classes include stocks, bonds and money market instruments. The desired allocation of funds can be achieved through different styles of asset allocation strategies known as Strategic Asset Allocation, Tactical Asset Allocation and Dynamic Asset Allocation.
At SAMI we believe our style is Dynamic Asset Allocation. Dynamic asset allocation is a portfolio management strategy that involves rebalancing a portfolio so as to bring the asset mix back to its long-term target. Such rebalancing would generally involve reducing positions in the best-performing asset classes while adding to positions in underperforming assets. The general premise of dynamic asset allocation is to reduce the fluctuation risks and achieve returns that exceed the target benchmark .
Our Asset allocation is based on the ratio of total market cap over GDP. The valuation indicator used by Warren Buffett is the percentage of total market cap (TMC) over the U.S. GNP. Since the actual difference between GNP and GDP is minimal, our stock market valuation based on the total market cap over GDP is a very good indicator. When the ratio is below 50%, the market is significantly undervalued. When the ratio is between 50% and 75%, the market is modestly undervalued. When the ratio is among 75% to 90%, the market is fairly valued. When the ratio is between 90% and 115%, the market is modestly overvalued. Otherwise, the market is significantly overvalued.