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Understanding Active Asset Allocation

The Two Types of Active Allocation

[By Jeffrey S. Coons; PhD, CFA]

[By Christopher J. Cummings; CFA, CFP™]

ACASometimes, physician investors feel that the markets either overreact or under react to a given piece of news – related to a specific security – and are generally willing to commit their time and resources to find mispriced securities.  

For example, a young physician with a long time horizon may feel that the financial markets are too focused on the near-term following a decline in a pharmaceutical company’s stock from a disappointing FDA report.  Or, the recent banking industry debacle is a good sector wide example of abrupt depression. 

And so, if active asset allocation makes sense based upon the limitations of passive asset allocation in managing risk over even long periods of time, how do physician investors – and their advisors – make active asset allocation decisions?   

The Approaches 

There are two distinct active asset allocation approaches used to build an investment portfolio.   They are the top-down method and the bottom-up method, and they differ based on how important economic and industry variables are to the decision-making process relative to individual security variables.  

Top-Down Approach

Advocates of the top-down approach generally begin their investment process by formulating an outlook for the domestic economy, and in certain circumstances the outlook is constructed for the global economy.  This may be a direct result of a quantitative model using various market and economic data as input to reach a conclusion regarding the best asset mix on a tactical basis, or it may be a more subjective process resulting from a qualitative assessment of the market and economic outlook.

In developing an economic overview for qualitative top-down asset allocation decisions, the medical professional and/or his advisors typically consider factors such as monetary policy, fiscal policy, trade relations, and inflation. Clearly, macroeconomic factors such as those listed above are likely to have a significant impact on the performance of a wide range of investment alternatives.

After a thorough analysis of the overall economy has been completed, top-down investors will either buy broad baskets of stocks representing an asset class or perform an analysis of industries that they believe will benefit from the economic overview that has been developed. 

Factors that may influence the attractiveness of particular industries include regulatory environment, supply and demand of resources, taxes, and import/export quotas. 

The top-down approach generally views the best company in a weak industry as being unlikely to provide satisfactory returns.  

The final step in the top-down process involves analyzing individual companies in industries that are expected to benefit from the forecasted economic environment.  

Stock_Market

Bottom-Up Approach

In contrast, investors employing a bottom-up approach will focus their attention on identifying securities that are priced below the investor’s estimate of their value.

Physicians and investors using the bottom-up approach to asset allocation and portfolio construction will only purchase securities deemed attractive according to their basic pricing and security selection criteria, thus adjusting the overall mix of investments by the limit of securities considered attractive at current valuations.

A truly bottom-up approach will consider economic and industry factors as clearly secondary in identifying investment opportunities. Investors using this approach will focus solely on company analysis.   However, they must recognize that investment decisions cannot be made in a vacuum.  Macroeconomic factors, as well as industry characteristics and traits are likely to be key elements in identifying attractive investment opportunities even on a security-by-security basis.

The key to bottom-up asset allocation and portfolio management is to realize that the decision variables driving the basic mix of assets in the portfolio are more related to the availability of attractive individual investments than to a general top-down market or economic overview.

Are you an active or passive investor?

If an active investor; what type are you?

Conclusion

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One Response

  1. Gene Fama’s Nobel Work
    [Active Managers Fated to Lose]

    http://www.financial-planning.com/news/famas-work-shows-active-managers-fated-to-lose-to-indexes-2686917-1.html?ET=financialplanning:e15199:86235a:&st=email&utm_source=editorial&utm_medium=email&utm_campaign=FP_Daily__101513

    The work that earned Eugene Fama PhD the Nobel Prize in economics provided the intellectual foundation for index-tracking funds, which have upended stock picking as investors abandon active money managers.

    http://www.fa-mag.com/news/fama-unrepetant-on-mpt–alternative-investments-and-the-value-of-advisors-15748.html

    Dr. David Edward Marcinko MBA CMP™
    http://www.CertifiedMedicalPlanner.org

    http://www.amazon.com/Financial-Planning-Handbook-Physicians-Advisors/dp/0763745790/ref=sr_1_1?ie=UTF8&s=books&qid=1275315635&sr=1-1

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