Integrated asset allocation provides a framework for viewing the key elements of the important asset allocation decision. Its general perspective subsumes more traditional asset allocation procedures in current use, including strategic, tactical and insurance approaches.
Integrated asset allocation is concerned with the optimization of an investor’s net worth. It thus deals with expected net worth (assets less liabilities) and standard deviation of future net worth, given the investor’s willingness to take on added net worth risk in order to increase expected net worth.
The asset allocation procedure involves several major steps. The investor’s current net worth is transformed, via a risk tolerance function, into the investor’s risk tolerance. At the same time, current capital market conditions—prices, earnings, dividends—are transformed (via a heuristic or complex process) into expected returns, risks and correlations for various asset classes. Given these predictions and the investor’s risk tolerance, an “optimizer” (ranging in complexity from a simple rule of thumb to a full-scale quadratic program) determines the most appropriate asset mix. The mix determines actual returns to the investor over the period. These returns feed back, via investor net worth and capital market conditions, into the next period’s allocation procedure.