Key Takeaways
- Asset allocation is the MOST important factor in determining long-term portfolio returns.
- Strategic asset allocation sets long-term target percentages based on client goals.
- Tactical asset allocation makes SHORT-TERM adjustments to capitalize on market conditions.
- Rebalancing returns the portfolio to target weights when allocations drift.
- Dollar-cost averaging invests fixed dollar amounts at regular intervals regardless of price.
- DCA buys MORE shares when prices are LOW and FEWER shares when prices are HIGH.
- Passive strategies (buy-and-hold) assume markets are efficient.
- Active strategies attempt to outperform through security selection or market timing.
Asset Allocation Strategies
Asset allocation is the process of dividing investments among different asset classes. Studies show it is the most important factor determining long-term portfolio returns—more important than individual security selection or market timing.
Types of Asset Allocation
Strategic Asset Allocation
Strategic allocation sets long-term target percentages based on the client's goals, risk tolerance, and time horizon.
| Characteristic | Description |
|---|---|
| Time Frame | Long-term (years to decades) |
| Approach | Buy-and-hold philosophy |
| Changes | Only when client's situation changes |
| Rebalancing | Periodic return to target weights |
| Philosophy | Markets are relatively efficient |
Sample Strategic Allocations
| Risk Profile | Stocks | Bonds | Cash |
|---|---|---|---|
| Conservative | 30% | 50% | 20% |
| Moderate | 60% | 30% | 10% |
| Aggressive | 80% | 15% | 5% |
| Very Aggressive | 95% | 5% | 0% |
Tactical Asset Allocation
Tactical allocation makes short-term deviations from strategic targets to capitalize on market conditions.
| Characteristic | Description |
|---|---|
| Time Frame | Short-term (weeks to months) |
| Approach | Active, opportunistic |
| Changes | Frequent, based on market views |
| Goal | Capture additional returns |
| Philosophy | Markets can be timed |
Tactical Strategies
| Strategy | Description |
|---|---|
| Sector Rotation | Shift between sectors based on economic cycle |
| Market Timing | Increase/decrease equity exposure |
| Style Rotation | Shift between growth and value |
| Geographic Rotation | Move between domestic and international |
Strategic vs. Tactical Comparison
| Factor | Strategic | Tactical |
|---|---|---|
| Frequency of changes | Rare | Frequent |
| Costs | Lower | Higher |
| Consistency | High | Variable |
| Requires forecasting | No | Yes |
| Tax efficiency | Better | Worse |
Exam Tip: Strategic allocation is LONG-TERM and changes only when client circumstances change. Tactical allocation is SHORT-TERM and changes based on market conditions.
Rebalancing
Rebalancing returns the portfolio to its target allocation after market movements cause drift.
Why Rebalance?
| Reason | Explanation |
|---|---|
| Maintain risk level | Drift changes portfolio risk profile |
| Discipline | Forces "buy low, sell high" |
| Align with goals | Keep portfolio matched to objectives |
| Remove emotion | Systematic, not reactive |
Rebalancing Example
Target: 60% stocks / 40% bonds
| Asset | Target | After Market Moves | Action |
|---|---|---|---|
| Stocks | 60% | 70% | Sell stocks |
| Bonds | 40% | 30% | Buy bonds |
Rebalancing Methods
| Method | How It Works | Pros/Cons |
|---|---|---|
| Calendar | Rebalance at fixed intervals (quarterly, annually) | Simple but may miss opportunities |
| Threshold | Rebalance when allocation drifts beyond ±5% | More responsive but requires monitoring |
| Hybrid | Check on schedule, rebalance if threshold exceeded | Balanced approach |
Rebalancing Considerations
| Factor | Impact |
|---|---|
| Transaction costs | May offset benefits of frequent rebalancing |
| Taxes | Selling winners triggers capital gains |
| Time | More frequent = more work |
| Tax-advantaged accounts | Rebalance here to avoid taxes |
Dollar-Cost Averaging (DCA)
Dollar-cost averaging involves investing a fixed dollar amount at regular intervals regardless of price.
How DCA Works
| Month | Investment | Share Price | Shares Purchased |
|---|---|---|---|
| 1 | $500 | $50 | 10.0 |
| 2 | $500 | $25 | 20.0 |
| 3 | $500 | $40 | 12.5 |
| 4 | $500 | $50 | 10.0 |
| Total | $2,000 | Avg. price: $41.25 | 52.5 shares |
Key Insight: Average cost per share ($2,000 ÷ 52.5 = $38.10) is LESS than average price ($41.25)
Benefits of DCA
| Benefit | Explanation |
|---|---|
| Lower average cost | Buy more shares when prices are low |
| Reduces timing risk | Avoids investing all at a market peak |
| Removes emotion | Systematic, disciplined approach |
| Simple | Easy to implement and maintain |
| Good for beginners | Establishes regular investing habit |
Limitations of DCA
| Limitation | Explanation |
|---|---|
| May underperform lump-sum | In rising markets, investing early beats DCA |
| No profit guarantee | If market declines continuously |
| Transaction costs | Multiple purchases may incur fees |
| Opportunity cost | Uninvested cash earns less |
Exam Tip: Dollar-cost averaging results in purchasing MORE shares when prices are LOW and FEWER shares when prices are HIGH. This lowers the average cost per share.
Passive vs. Active Management
Passive Management
| Characteristic | Description |
|---|---|
| Goal | Match a benchmark's return |
| Strategy | Buy-and-hold, index funds |
| Costs | Lower expense ratios |
| Turnover | Low |
| Belief | Markets are efficient |
Active Management
| Characteristic | Description |
|---|---|
| Goal | Outperform a benchmark |
| Strategy | Security selection, market timing |
| Costs | Higher expense ratios |
| Turnover | Higher |
| Belief | Can identify mispriced securities |
Efficient Market Hypothesis (EMH)
| Form | Description | Implication |
|---|---|---|
| Weak | Prices reflect all past price data | Technical analysis doesn't work |
| Semi-Strong | Prices reflect all public information | Fundamental analysis doesn't work |
| Strong | Prices reflect all information (public + private) | No one can consistently outperform |
Active vs. Passive Comparison
| Factor | Active | Passive |
|---|---|---|
| Fees | Higher (1-2%+) | Lower (0.03-0.20%) |
| Tax efficiency | Lower | Higher |
| Performance | Variable, often underperforms | Matches benchmark |
| Manager risk | Yes | No |
Exam Tip: Asset allocation is the PRIMARY determinant of long-term returns—more important than security selection or market timing.
What is the PRIMARY purpose of portfolio rebalancing?
Which allocation strategy makes SHORT-TERM changes based on market conditions?
An investor using dollar-cost averaging will:
According to investment research, what is the MOST important factor in determining long-term portfolio returns?
8.3 Measuring Portfolio Performance
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