Asset Allocation Strategies

Asset allocation--the distribution of portfolio assets among different asset classes--is the most important investment decision an investor makes. According to landmark research, asset allocation accounts for the vast majority of portfolio performance, making it essential knowledge for CFP professionals.

The Brinson Study: Why Asset Allocation Matters

The 1986 study by Gary Brinson, Randolph Hood, and Gilbert Beebower (BHB) fundamentally changed how investors think about portfolio construction. By analyzing 91 large U.S. pension funds over a decade, they discovered that asset allocation policy explains over 90% of the variability in portfolio returns over time.

Key findings from the Brinson studies:

• 1986 study: Asset allocation explained 93.6% of return variability (R-squared)
• 1991 update: Confirmed at 91.5% of return variability
• The remaining ~10% comes from security selection and market timing

Important distinction: The Brinson study measured return variability (how much returns fluctuate), not return levels. As clarified by Ibbotson and Kaplan (2000), asset allocation explains:

• ~90% of return variability over time for a given portfolio
• ~40% of return variation among different funds

CFP Exam Tip: Remember that asset allocation explains over 90% of portfolio return variability. This emphasizes why getting the asset mix right is more important than individual security selection.

Strategic Asset Allocation (SAA)

Strategic asset allocation establishes long-term target weights for each asset class based on the investor's objectives, risk tolerance, and constraints as documented in the Investment Policy Statement (IPS).

Characteristics of strategic allocation:

• Long-term focus (typically 5+ years)
• Based on capital market expectations and investor profile
• Provides the baseline or "policy portfolio"
• Assumes reversion to long-term risk/return expectations
• Discipline-based: resists emotional reactions to market movements

Example strategic allocation for a moderate investor:

Tactical Asset Allocation (TAA)

Tactical asset allocation involves short-term deviations from strategic targets to capitalize on perceived market opportunities or to reduce exposure to anticipated risks.

Characteristics of tactical allocation:

• Short-term focus (typically 12-36 months)
• Requires active management and market views
• Operates within pre-defined ranges (e.g., +/-5% from strategic weights)
• Attempts to add alpha through timing
• Higher transaction costs than purely strategic approach

Example: A portfolio manager believes European equities are undervalued. The IPS allows tactical tilts of +/-5%. They increase international equity allocation from 15% to 20% (strategic target + 5%) while reducing U.S. equity proportionally.

Dynamic Asset Allocation

Dynamic asset allocation is similar to tactical allocation but incorporates long-term changes in market expectations rather than short-term timing. It systematically adjusts targets based on:

• Changes in investor circumstances (age, wealth, goals)
• Secular shifts in capital market expectations
• Changes in economic cycles
• Life-cycle considerations (target-date funds)

Example: A target-date retirement fund automatically shifts from equity-heavy to bond-heavy as the target date approaches. This is dynamic allocation driven by changing time horizon and risk capacity.

Constant-Weighting vs. Buy-and-Hold Strategies

These two fundamental approaches determine how portfolios evolve over time:

Constant-Weighting Strategy (Constant-Mix):

• Maintains fixed target percentages for each asset class
• Requires periodic rebalancing to restore targets
• Sells winners and buys losers (contrarian approach)
• Assumes asset class returns are mean-reverting
• Works well in oscillating, trendless markets

Buy-and-Hold Strategy:

• Sets initial allocation but does not rebalance
• Allows allocations to drift with market movements
• Winners become larger portfolio weights over time
• Lower transaction costs (no rebalancing trades)
• Works well in strongly trending markets
• Risk profile changes as allocations drift

Rebalancing Strategies

Rebalancing restores portfolio allocations to target weights. Two primary approaches exist:

Calendar-Based Rebalancing:

• Rebalances on fixed dates (monthly, quarterly, semi-annually, or annually)
• Simple to implement and administer
• Predictable trading schedule
• May rebalance unnecessarily in stable markets
• May miss urgent adjustments in volatile markets

Threshold-Based Rebalancing (Percentage-of-Portfolio):

• Triggers when allocations deviate beyond set limits (e.g., 5% from target)
• Responds to actual market movements
• May have lower transaction costs (trades only when needed)
• Requires ongoing monitoring
• More responsive in volatile markets

Example: A portfolio has a 60% equity target. Under a 5% threshold rule, rebalancing occurs when equity allocation exceeds 65% or falls below 55%.

CFP Exam Tip: Threshold-based rebalancing outperforms calendar-based in volatile markets, but calendar-based is easier to implement and good for tax planning. Many advisors use a hybrid approach.

Tax-Efficient Rebalancing Considerations

For taxable accounts, rebalancing strategies should consider:

• Tax-loss harvesting: Offset gains with losses when rebalancing
• Asset location: Hold tax-inefficient assets in tax-deferred accounts
• New contributions: Direct new investments to underweight asset classes
• Withdrawal timing: Sell overweight assets for needed distributions
• Wash sale rules: Avoid repurchasing "substantially identical" securities within 30 days