## **Learning Outcomes**

This article explains the core principles of portfolio asset allocation and rebalancing within the CFA Level 1 curriculum context. It clarifies how asset allocation determines the majority of a portfolio’s risk and return, and contrasts long-term strategic allocation with shorter-term tactical adjustments to a policy mix. The article explains how investor objectives, risk tolerance, time horizon, and constraints shape the strategic asset mix, and how tactical shifts are implemented without violating the investment policy statement. It details why portfolios drift away from target weights over time and analyzes the rationale for systematic rebalancing to maintain the intended risk profile. The discussion compares calendar-based and threshold-based rebalancing methods, evaluates their advantages, limitations, and typical exam traps, and highlights how transaction costs and taxes influence rebalancing decisions. Finally, the article outlines the practical implementation steps for designing an asset allocation, selecting appropriate instruments, monitoring deviations, and executing rebalancing trades, reinforcing how these processes integrate into a disciplined, repeatable portfolio management framework tested in the CFA Level 1 exam.

## **CFA Level 1 Syllabus**

For the CFA Level 1 exam, you are expected to understand the concepts and practical steps in constructing and maintaining effective investment portfolios, including the rationale for asset allocation, the application of portfolio rebalancing, and the impact of these processes on investor objectives, with a focus on the following syllabus points:

- Explaining the importance of asset allocation as the main determinant of portfolio risk and return
- Distinguishing between strategic and tactical asset allocation approaches
- Describing factors influencing the asset allocation decision, including investor constraints and goals
- Outlining common portfolio rebalancing methods and their relative merits
- Identifying triggers and implementation steps for rebalancing processes

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which asset allocation approach typically remains unchanged except for periodic reviews: strategic or tactical?
2. What is the primary reason for regular portfolio rebalancing?
3. Name one trigger that might prompt a portfolio rebalancing event.
4. In the context of asset allocation, what is a policy mix?

## **Introduction**

Asset allocation and rebalancing are the heart of successful investment portfolio management. Deciding how much to invest in each asset class is the main determinant of a portfolio’s level of risk and return. Over time, market movements can shift the actual asset allocation away from the intended mix, changing the risk profile. Regular rebalancing is required to ensure the portfolio stays aligned with investor preferences and long-term objectives.

> **Key Term: asset allocation**
> The process of dividing an investment portfolio among different asset classes, such as equities, bonds, and cash, to achieve desired risk and return objectives.
>
> **Key Term: rebalancing**
> The act of adjusting a portfolio’s holdings back to the target asset allocation, typically by selling overweight assets and buying underweight assets.

## THE ROLE OF ASSET ALLOCATION

Asset allocation is the decision-making process that establishes how a portfolio’s capital is distributed across asset classes. This allocation determines portfolio performance far more than individual security selection. Diversifying asset exposure manages risk and pursues growth by allocating across asset classes with differing risk-return characteristics.

> **Key Term: diversification**
> The reduction of portfolio risk by investing in different assets that are not perfectly correlated.

## STRATEGIC VS TACTICAL ASSET ALLOCATION

Approaches to asset allocation fall into two main categories:

- **Strategic asset allocation**: The investor’s long-term, baseline policy for dividing capital among asset classes. This allocation is based on the investor’s goals, risk appetite, investment horizon, and constraints, and is typically described as a policy mix.
- **Tactical asset allocation**: Shorter-term shifts away from the long-run policy mix to take advantage of expected market opportunities. Tactical allocation aims to increase return, control risk, or both, in response to current economic conditions or market valuations, but must stay consistent with the investor's tolerance and investment policy.

> **Key Term: policy mix**
> The long-term target allocation proportions to asset classes outlined in an investor’s investment policy statement.
>
> **Key Term: tactical asset allocation**
> A temporary adjustment to the baseline (strategic) asset allocation in response to perceived market opportunities or risks.

### **Worked Example 1.1**

**Question:**  
An investor’s strategic policy is 60% equities, 30% bonds, and 10% cash. After a rally in equities, the allocation shifts to 70% equities, 25% bonds, and 5% cash. What should be done to realign with the policy?

> **Answer:**  
> The portfolio should be rebalanced by selling equities and buying bonds and cash to restore the 60:30:10 policy target.

## WHY REBALANCE

Over time, stronger performance in certain asset classes will cause a portfolio to “drift” from target weights, leading to unintended risk and return exposure. Rebalancing restores alignment with the original strategy and objectives by systematically selling assets that have risen above target and buying those that are below target.

Benefits of rebalancing include:

- Maintaining the desired risk profile
- Enforcing a disciplined investment process
- Realizing profits on winners and managing losses on underperformers

However, rebalancing also involves transaction costs and potential tax consequences, so the decision to rebalance must account for these alongside the benefits.

## REBALANCING METHODS

Several approaches can be used to rebalance a portfolio:

- **Calendar-based rebalancing**: Rebalancing at regular intervals (e.g., quarterly, annually)
- **Threshold-based (tolerance band) rebalancing**: Rebalancing only when an asset class's allocation drifts outside a set percentage from target (e.g., ±5%)
- **Combination approach**: Using both a calendar and threshold rule

> **Key Term: threshold rebalancing**
> A method where rebalancing is triggered when allocations deviate outside predefined percentage bands from the target mix.

### **Worked Example 1.2**

**Question:**  
A target policy for bonds is 30%. The rebalancing threshold is ±5%. If the bond allocation reaches 36%, what should the advisor do?

> **Answer:**  
> Because 36% exceeds the upper 35% threshold (30% + 5%), the portfolio should be rebalanced by selling bonds to bring the allocation back to target.

### **Exam Warning**

> Be careful: On the exam, you may be asked whether transaction costs or taxes could sometimes make it rational to delay rebalancing—even after large drifts from the policy weights. Evaluate both benefits and costs before selecting an answer.

### **Revision Tip**

> Portfolio drift is often tested through numerical scenarios. Practice calculating the effect of asset class price changes on portfolio weights, and review how and when to implement threshold versus calendar rebalancing.

## IMPLEMENTING ASSET ALLOCATION AND REBALANCING

Implementing an asset allocation or rebalancing plan involves:

1. Assessing investor goals, risk tolerance, time horizon, liquidity needs, and constraints
2. Determining the long-term target asset mix and risk/return expectations
3. Developing a policy mix and documenting it in an investment policy statement
4. Selecting investments to represent each asset class in line with the policy mix
5. Monitoring portfolio values and tracking deviations from targets
6. Executing rebalancing trades as required by the chosen method

### **Worked Example 1.3**

**Question:**  
An investor’s policy mix is 50% equities, 40% bonds, 10% cash. Due to a market correction, bonds now make up 48% of the portfolio, equities 45%, cash 7%. If using a threshold method with 5% tolerance bands, must rebalancing occur?

> **Answer:**  
> No. All asset classes are within ±5% of their targets (equities: 45–55%; bonds: 35–45%—bonds have slightly breached; so a rebalancing should occur to bring bonds back to target. (Correction: bonds should be 35–45%, so at 48%, bonds are above the threshold; therefore, rebalance.)

## **Summary**

Asset allocation sets the portfolio’s long-term structure, far outweighing individual security selection in importance to overall investment outcomes. Rebalancing keeps the portfolio aligned to investor goals and target risk exposure. Both steps must consider costs, taxes, and practical constraint, and should be documented in the investment policy. Strategic allocation offers discipline and stability; tactical shifts may offer slightly higher returns or lower risk, for those able and willing to make them, but should not undermine the core policy. A repeatable rebalancing process supports consistency and limits emotional decision-making.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Asset allocation is central to portfolio construction and risk control
- Strategic allocation is the long-term target mix, while tactical allocation is short-term deviation
- Rebalancing corrects drift from allocation targets to preserve intended risk/return
- Rebalancing may be triggered by time intervals (calendar) or threshold bands
- Transaction costs and taxes must be considered before rebalancing
- Documentation of allocation and rebalancing plans in policy is essential

## **Key Terms and Concepts**

- asset allocation
- rebalancing
- diversification
- policy mix
- tactical asset allocation
- threshold rebalancing

Portfolio construction and analytics - Asset allocation and rebalancing