Dynamic approach to asset allocation

[myriam2222]

I am trying to understand in practice what dynamic asset allocation is.
The definition and the content in the material related to this topic are very limited, quite easy to learn by heart and stupidly reuse during the exam but I can’t remember things well if i don’t fully understand.
The material says: “A dynamic approach recognizes that an investor’s asset allocation and actual asset returns and liabilities in a given period affect the optimal decision that will be available next period. The asset allocation is further linked to the optimal investment decisions available at all future time periods.” Then it says something about its cost, the fact that it applies to AO and ALM both, but is frequent in the context of an ALM approach.
And that’s it I think! Not much really!
In practice, here is how I imagine it could go:
1) Very easy but this is not how I understand it from the definition: at the end of each period (“a period” of course would need to be defined), the asset manager reviews the allocation depending on how the portfolio has performed during the previous period and how such performance affects the client’s return and risk objectives.
2) A bit more tricky but this is how I understand it from the definition: when the asset allocation is initially defined, it is foreseen from the beginning that the asset allocation will be modified at the end of each period, and the actions that will be taken are already defined at the very beginning, using a lot of assumptions like: “if the return so far has been below target by that much, then the allocation will be changed to reach x% of investment in equity, x% in bonds, etc. If the return has been above target, then…. If the efficient frontier has changed, then the asset allocation should be modified towards the new efficient portfolio for the revised risk tolerance. Etc.”
Meaning in case 2, no decision is taken at the end of each period, only action, as the decisions have been all initially made at the beginning, which implies a lot of conditionnal decisions to cover all possible cases.
What do you think?
thanks!

 

[daharmattan1]

You have the major concept down so don’t get bogged down.
In terms of rebalancing, the curriculum will have a later section that discusses portfolio rebalancing and the various risk and tradeoffs in the different approaches using calendar rebalancing, or risk tolerances etc. That’s where that concept would actually be tested/show up on the exam.

 

[Arbtrgr]

My understanding is that what you are deciding on is the allocation at the beginning of the first period, but keeping in mind how that will affect your decisions in subsequent periods.
The purpose of the exercise is to make a decision at t=0. At t=1 you would repeat the dynamic asset allocation, rather than execute what you thought was going to happen right at the start.
Now you can revisit the inputs to your model, and perhaps your model itself.
Essentially dynamic asset allocation takes a multiperiod view right at the beginning and the static just looks at 1 period.
I think that your “2)” is more or less that. Having said that, I agree with daharmattan1 that you have the major concept down. The important take away is that this is costly, as one would require resources in order to perform the many permutations, but potentially provide superior results over a long period, if the model and the inputs are accurate of course, as this would be quite sensitive I imagine.

 

[myriam2222]

Thank you.
Yes I have the major concept down as you said. But as I was mentioning, I need to have a concrete view of what it means otherwise I can’t remember and I will forget for the exam. That’s my major problem with Level III I think, I don’t fully retain something that I did not fully understand (almost to the point I could use it in practice). For me it’s all or nothing I am afraid.
Thanks!

 

[cpk123]

myriam - if you have read all of the curriculum already and are mulling now through the all-or-nothing part - then I would agree with you. If you are still reading the Asset Allocation portion of the curriculum in order from the start of the curriculum - and are saying that - then I should tell you that the curriculum builds on itself - and until you finish the whole - you would not get the picture. So take it easy if you are in the 2nd camp - reading through the curriculum now for the first time. Do not add stress by saying it is “all or nothing” now.