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Explain strategic asset allocation and how a portfolio is rebalanced

CFA® Level I · Portfolio Management · Basics of Portfolio Planning and Construction · PM.3.d

The idea

Strategic asset allocation translates objectives and constraints into long-term target weights for asset classes, and is the decision that explains most of the variation in a portfolio's returns over time. Because asset classes grow at different rates, actual weights drift away from targets, raising exposure to whatever has performed best — often just as it has become more expensive. Rebalancing restores the targets, either on a calendar schedule or when a weight breaches a tolerance band. It is contrarian by construction, which is why it is psychologically difficult and why the policy should be written down in advance.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does strategic asset allocation set?

  1. The list of individual securities to holdWhy not: Security selection happens inside each asset class, after the allocation has been decided.
  2. Long-term target weights for asset classes — correct
  3. The timing of purchases within a quarterWhy not: An execution matter. Strategic allocation is about long-term weights, not when orders are placed.

It operates at the asset class level and over long horizons, which is what distinguishes it from security selection and tactical shifts.

A harder one

Why is rebalancing described as inherently contrarian?

  1. Because it requires selling what has risen and buying what has fallen — correct
  2. Because it is performed only in bear marketsWhy not: It is performed on a schedule or when bands are breached, in rising and falling markets alike.
  3. Because it reduces the number of asset classes heldWhy not: It restores the weights of the classes already held; nothing is dropped.

Restoring target weights means trimming the winners. That is the opposite of what momentum and comfort suggest, which is exactly why a written rule helps.

The hardest tier

What risk does an un-rebalanced portfolio accumulate over a long bull market in equities?

  1. Excessive cash holdingsWhy not: Cash is the asset whose weight shrinks when equities rise, so the drift runs the other way.
  2. Loss of exposure to the best-performing assetWhy not: Without rebalancing the winner's weight grows, which is exactly the problem: the exposure increases rather than lapses.
  3. A rising equity weight — correct

Risk is then highest precisely when valuations are most stretched. Drift silently converts a balanced policy into an aggressive one without any decision being taken, and the investor discovers the new risk level only in the subsequent decline.

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