A further extension of investment strategy, asset allocation is a process that utilizes various means of risk control to apportion assets in a manner consistent with the objectives and constraints that the planner and client have codified in the investment policy statement. Whereas the strategy types in the prior chapter focus on implementation and risk management, asset allocation concentrates on the attainment of the appropriate mix within the framework of these two processes. Asset allocation serves to achieve appropriate diversification and is very much a dynamic process. Candidates can expect a number of questions on the processes and rationale behind portfolio diversification.

Strategic Asset Allocation
This is the long-term apportionment of asset classes and subclasses consistent with the client's objectives. Strategies may be passive, utilizing index funds or a buy-and-hold approach; active in pursuit of alpha through individual security selection or the use of professional management (separate account, mutual fund or alternative investment); or semi-active which entails some form of enhancement to a passive approach.

  1. Application of client life cycle analysis - the analysis of an investor's risk tolerance and constraints form the basis for the creation of the investment policy statement and subsequent asset and strategy selection.
  2. Client risk tolerance measurement and application - consultative questioning and a more thorough understanding of the client enable the planner to understand the client's ability to bear risk. Risk tolerance measurement should be part of the initial counseling and analysis that ultimately will lead to the proper formulation of investment policy.
  3. Asset class definition and correlation - the investment policy statement will define the asset classes needed to implement the appropriate strategy. Care should be taken in understanding their interrelation and degree of correlation that should be consistent with the strategy to be pursued.

Rebalancing
Rebalancing is nothing more than the systematic and periodic realignment of the portfolio to its target weights. The purpose of doing so is to prevent the portfolio's performance from being driven or dominated by one security or asset class or subclass. Securities whose value has increased beyond its portfolio target are sold and those which have experienced a decrease in value to below their target weight are purchased with the overall goal of keeping the portfolio in balance. Frequency of rebalancing is a consideration in taxable accounts. As it may generate a taxable event and entails transaction costs of buying and selling, rebalancing should not be conducted too frequently. These points are moot in a tax deferred retirement account where transaction costs may be less of an issue and no taxable event occurs.

Tactical Asset Allocation
Tactical asset allocation involves the periodic and opportunistic shifts between asset classes to take advantage of or avoid certain market tendencies. Such activity occurs within the context of the overall strategic asset allocation and is not designed to override it.

Control of Volatility
Risk management is a critical ongoing function pursuant to policy formation and strategy implementation. The investment policy statement, because it is designed to be consistent with the client's objectives and constraints, should have at its core a strategy for managing risk consistent with the client's ability to bear it.


Concentrated Stock Portfolio Strategies

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