Strategic asset allocation (SAA) is the process of creating a long-term investment plan. Its aim is to preserve and grow your wealth over time, while meeting your risk objectives.

Left entirely in cash, your wealth may lose purchasing power, especially over long periods, as inflation eats away at it. 

So, creating a long-term plan involves determining a suitable mix of asset classes. 

What represents a suitable mix depends on your circumstances, such as the returns you’d like to target, how much risk you’re willing to pursue, whether you are comfortable locking away your money for longer periods and so on.

Put simply, SAA is not a one-size-fits-all process!

A plan can involve investing in many sectors such as cash, equities, fixed income, real estate, hedge funds and private equity .

Investors sometimes also put money into art, fine wine or farmland.

However, not all these asset classes are suitable for every investor.

Which you include in your plan – and how much you plan to hold of each – will depend partly on your appetite for risk. 

If you’re willing to tolerate more risk you may allocate more to asset classes with higher potential returns. The flipside is that they come with higher risk.

There’s no one definition of risk. Some define it as “volatility” or how much prices move around.

Others care more about “downside” – or how far an asset class might fall during a crisis.

You might wonder why you’d bother having a mix of asset classes rather than simply investing everything in one or two you think may perform well.

The reason is that putting all your eggs in one or two baskets is risky. You could easily end up with negative returns while having taken much more risk than sitting in cash.

Having a mix of asset classes from different regions and industries may be a more effective investment strategy in the long term, striking a better balance between risk and reward.

The key here is how they work together. Because different asset classes have often done well and badly at different times in the economic cycle, you can potentially earn positive returns above inflation over time while mitigating some of the risks. However, past performance is not indicative of future returns.

Staying invested for the long term is also critical to SAA. Over long periods, you can potentially benefit from compound returns, or returns on previously earned returns.

Having a long-term investment plan can provide vital discipline. 

Without a plan, human psychology may easily take over. You might find yourself investing based on emotions, for example buying a share because you don’t want to miss out or selling one in a sound company just because the market falls. 

Trying to time the market, which means trying to buy when markets are rising and avoiding big losses, may also be tempting, but usually ends in failure. 

So, having a plan based on sound principles can help reassure you in the bad times and keep you focused on what really matters.

There are different approaches to determining suitable asset allocations. 

But all approaches should have some common features.

They need to have a view about how each asset class may perform over several years, what risks are involved and how the different asset classes might work together.

Typically, this requires a lot of data and heavy number crunching.

Of importance is taking into consideration your investment goals, investment horizon and risk appetite. 

For example, you might want to invest more heavily in your own country or region. Or you may decide against holding certain assets such as commercial property, which can be harder to sell quickly.  

Developing a long-term plan based on your circumstances is the first step. 

You might then make adjustments to your plan based on your market outlook for the next 12-18 months. This is called tactical asset allocation.

Next, you need to put the plan into action.

As we’ll see in the next article, portfolio construction is the process of filling your basket with investments that match your plan.

After that, you should look to rebalance your plan regularly adjust your portfolio accordingly.