Question

a. There is considerable debate as to whether asset returns are generated by asset allocation, stock selection or a combination of both. Define the terms: asset allocation and stock selection. Compare tactical asset allocation and active stock selection. Could investors make a profit by using these strategies?

Answer 1

Asset allocation is the process of determining the different asset classes to be held in a portfolio, and the proportion of each asset class in the portfolio. It is based on the investor's return requirements, risk tolerance and other important factors in the investor's investment policy.

Stock selection is the process of identifying individual stocks for investment in order to earn an excess risk-adjusted return. Stock selection can be done through different methods such as technical analysis, fundamental analysis etc. It seeks to identify mispriced securities in order to earn a superior return.

Tactical asset allocation is a strategy where the asset allocation is changed from the underlying index to take advantage of short to medium term anomalies and sectoral mispricings. Certain sectors or asset classes are allocated as "overweight" or "underweight" based on perceived underpricing or overpricing, and the portfolio allocation is adjusted to profit from this view.

Active stock selection is a strategy where securities in a portfolio are actively selected instead of passively tracking the securities in an index. It seeks to achieve superior returns over the underlying index through actively managing the stock selection and their weights in the portfolio.

Whether investors could make a profit using these strategies is a huge debate amongst investment managers and academicians. There are equally strong and compelling arguments on both sides of the debate. There are those who strongly believe that profit cannot be made using these strategies. These are proponents of the Efficient Market Hypothesis. However, there are those who equally strong argue that profit can be made using these strategies. These are detractors of the Efficient Market Hypothesis. There is research on both sides to indicate that there is some truth to both arguments, however there are also findings that disprove the arguments. Thus, it remains to be seen which argument holds.