In this piece, we delve deeper into the concept of diversification to present the importance of asset allocation and rebalancing - two key factors in achieving and maintaining a disciplined, diversified portfolio.
The Benefits of Asset Allocation and Rebalancing
In New York City, savvy street vendors diversify their businesses by
selling both sunglasses and umbrellas. By carrying two items that
sell in very different weather conditions, the vendors have a product
to sell regardless of the weather. This concept of diversification can
be an effective marketing strategy. It can also be an effective
In a previous issue of Fundamentals, we discussed diversification, a widely
embraced investment strategy that can help reduce risk and volatility in a
portfolio. Rather than holding just one or two stocks, prudent investors diversify
their investment portfolios by selecting a mix of securities that are expected to
perform differently under different market conditions. Investing assets in
different types of securities spreads the risk, so that all of one’s assets are not
invested in just one security—or one type of security. Diversifying assets can
also reduce price volatility, as positively performing securities in the portfolio
help to offset poorly performing securities.
Fundamentals is a series of white
papers addressing a range of
topics related to constructing In this piece, we delve deeper into the concept of diversification to present the
and implementing an investment importance of asset allocation and rebalancing—two key factors in achieving
portfolio. This educational series and maintaining a disciplined, diversified portfolio.
has been created to help clients
understand relevant investment
strategies and vehicles. To learn What is Asset Allocation?
more about diversification and
how it can help you pursue your
Asset allocation is the strategic combination of securities from different asset
investment goals, please contact
your Financial Advisor. classes, such as cash equivalents, bonds and stocks, to create a diversified
investment portfolio. The term “asset class” describes a group of securities that
shares similar risk and return characteristics. Since different asset classes have
different risk and return characteristics, they are less than perfectly correlated
with each other, and there are potential benefits to be derived by combining
them in a portfolio. A well diversified portfolio contains a mix of securities
from each of the key asset classes:
• Cash instruments (e.g., certificates of deposit, Treasury bills and
money market funds)
• Fixed income (e.g., bonds and bond mutual funds)
• Equity (e.g., stocks and stock mutual funds)
ab UBS Financial Services Inc.
Today’s investors have greater access to different types of zero tolerance for risk below the floor value and an
investments. Blending different categories of securities within increasing risk appetite at levels above the floor value.
each asset class adds another layer of diversification to a
portfolio. It is possible to diversify one’s portfolio beyond Strategic – A third approach is strategic asset allocation or
the traditional cash, fixed income and equity investments to constant-mix allocation. In strategic asset allocation, the
include more focused sources of risk and return, such as: investor establishes target portfolio percentages for each
asset class, based on long-term capital market assumptions3
• Market capitalization (e.g., small-capitalization stocks) and the investor’s long-term attitude toward risk. The
investor makes periodic adjustments to restore this targeted
• Credit quality (e.g., high-yield bonds) portfolio mix as the relative values of the asset classes
change with respect to each other. Accordingly, the investor
• Economic sectors (e.g., transportation, technology, will sell those asset classes that have grown at a faster rate
healthcare) and buy those that have grown at a slower rate. Implicitly,
strategic asset allocation assumes that the investor’s risk
• Geographic regions (e.g., Europe, Asia, South America) tolerance does not change with short-term fluctuations in
the level of wealth; the investor will hold stocks in the
• Investment styles (e.g., growth, value) targeted proportion regardless of the direction of the
market. Nevertheless, in practice a constant mix target
Different Asset Allocation Strategies1 allocation can be reviewed periodically and revised to reflect
changes in the investor’s circumstances.
There are several approaches to asset allocation, which
differ in their required levels of active management and Tactical – In tactical asset allocation, the investor adjusts the
assumptions about investors’ risk tolerances, and about portfolio’s target asset allocation to reflect changes in his/her
changes in capital market expectations. Below are own shorter-term capital market expectations for the
descriptions of some of the most popular forms. different asset classes. Often, such adjustments reflect views
about future capital market developments that are contrary
Buy and Hold – The most basic approach to asset allocation to mainstream thinking. The investor reduces exposure to
is a buy-and-hold strategy, in which an investor determines asset classes that have appreciated beyond his/her estimate
an initial allocation—for example 40% cash equivalents and of fair value and reinvests the proceeds in asset classes he/she
60% stocks—and then holds this portfolio throughout estimates are undervalued. Like strategic asset allocation,
market fluctuations, without making adjustments. In the buy- tactical asset allocation implicitly assumes that an investor’s
and-hold approach, an investor will hold a greater risk tolerance is stable over the investment horizon,
percentage of stocks as stocks appreciate and a smaller regardless of the level of wealth. Unlike strategic asset
percentage of stocks as stocks depreciate. Thus, the buy-and- allocation, tactical asset allocation anticipates changes in the
hold approach to asset allocation implicitly assumes that the relative value of different asset classes and seeks to benefit
investor’s risk tolerance, defined as the willingness to hold from adjusting the portfolio mix before these changes occur.
stocks, changes with the level of wealth.
Integrated – A fully integrated approach to asset allocation
Insured – Another approach to asset allocation is insured would incorporate both changes in capital market
asset allocation, in which an investor adjusts the portfolio’s assumptions and investor risk tolerances and update the
allocation to stocks in relation to a predetermined portfolio
floor value, below which the portfolio should not fall.2 The
investor using an insured asset allocation will sell stocks as 1
This discussion summarizes “Dynamic Strategies for Asset Allocation,” by
they depreciate, reducing the allocation to stocks to zero as Andre F. Perold and William F. Sharpe, which appeared in the January-
February 1988 issue of Financial Analysts Journal, and “Asset Allocation,”
the portfolio value approaches the floor value. Conversely, Managing Investment Portfolios: A Dynamic Process, by William F. Sharpe.
the investor will buy more stocks as stocks appreciate and the The use of the term 'insured' in no way indicates that results are insured.
Although the insured asset allocation approach is intended to prevent the
portfolio rises farther above the floor value. Consequently, portfolio value from falling below a predetermined floor value, in the case
insured asset allocation explicitly assumes that the investor’s of an abrupt decline in the market, when an investor will not have time to
rebalance, the portfolio may fall below the floor value.
risk tolerance changes with levels of wealth—the investor has 3
Capital market assumptions generally include forward-looking estimates of
asset class risks, returns and correlations.
target allocation mix accordingly. This approach has the assumptions about changes in capital market expectations?
benefit of being the most comprehensive; however, it is also Or does the investor wish to take a more measured, long-
the most difficult and resource-intensive to implement. The term approach? The table below illustrates the features of
tactical element, in particular, can be very difficult to put into each asset allocation approach. The strategic allocation
effect and should be undertaken only by experienced approach tends to be popular among individual investors,
professionals. Fortunately, a substantial body of research as it is relatively easy to implement and the regular
indicates many of the benefits of an integrated approach can rebalancing helps instill discipline. Although past
be achieved through following strategic asset allocation, in performance is not necessarily indicative of future results,
spite of the relative simplicity of this form. historically, strategic asset allocation tends to outperform
other asset allocation approaches during an oscillating,
Selecting an Asset Allocation Strategy sideways market.
Selecting the best asset allocation approach depends on
an investor’s goals and preferences. For instance, does the
investor wish to actively trade the portfolio and formulate
Buy-and-Hold Strategic Tactical Insured Integrated
Rebalances to Target Allocation No Yes Yes Yes Yes
Assumes Changes in Investor’s Yes No No Yes Yes
Anticipates Changes in No No Yes No Yes
Capital Market Expectations
Works Best in: A Trending Market A Flat, * A Trending *
Fluctuating Market Market
Tactical and integrated asset allocation are less mechanical, more active approaches. Thus, they have the potential to work well in any market, but rely upon the
investor's skill in anticipating capital market changes.
Establishing an Asset Allocation Plan a much larger portion of their portfolios to fixed income
and cash-equivalent investments. Not surprisingly, their
Establishing an asset allocation plan is the first step toward potential for risk and reward (indicated by the triangle)
developing a disciplined, long-term investment strategy. will be less than that of the aggressive investors who hold
An asset allocation plan should reflect an investor’s unique larger portions of equity investments.
investment profile, based on personal circumstances,
including wealth, investment horizon, tolerance for risk
and financial objectives. These circumstances can
determine whether an investor is conservative or
aggressive, investing for the near term or the long term,
pursuing growth or income, etc. Careful attention to
these circumstances helps investors decide how the
portfolio should be allocated among each of the different
asset classes and investment categories. An asset allocation
plan reflecting an investor’s unique investment profile can
serve as a helpful blueprint for pursuing financial goals.
The chart at right provides a simplified example of how
asset allocation plans can vary from investor to investor.
For instance, conservative investors who have short time
horizons or very low tolerance levels for risk may allocate
Determining the Optimal Mix of Assets begins to improve. Thus, within strategic asset allocation
rebalancing can increase an investor’s chances of selling
Once an investor’s unique investment profile has been high and buying low. Even in trending markets, when this
determined, this profile should be evaluated in the context benefit of strategic asset allocation may be less evident,
of the available capital market opportunities. While some rebalancing still serves the important purpose of realigning
asset allocation plans are established using traditional the investor's portfolio with the targeted asset allocation to
approximations, many asset allocation plans rely on a reflect the investor's longer-term risk tolerance.
quantitative portfolio optimization model, which uses an
optimizer tool to help determine the appropriate mix of Rebalancing at Work
assets. The optimizer tool will combine the information
collected during the investor profiling process with Due to favorable market conditions over the past quarter,
historical or forward-looking assumptions for expected lets say that Mr. Smith’s portfolio has appreciated in value.
returns, risks and correlations of the various asset classes. As a result, his stock and bond allocations now exceed his
The optimizer tool will suggest an acceptable range for the original asset allocation strategy. If he opts not to rebalance
percentage allocation to each investment category that the portfolio, his current allocation will have more equity
either maximizes expected portfolio return for a given level and fixed income exposure than he desires. By trimming
of desired risk or minimizes risk for a desired level of back his stock and bond holdings and reallocating the
expected return. proceeds to the cash position, he will bring the current
allocation back in line with his original strategy.
The Importance of Rebalancing
A Hypothetical Example
Rebalancing is the periodic review of the current asset
allocation to identify and correct any deviation from the
original asset allocation strategy. More active forms of
asset allocation strategy (all except the buy-and-hold
strategy) involve some degree of rebalancing to help
preserve the intent of the asset allocation. An investor
rebalances the portfolio by purchasing or selling holdings
until the current asset allocation is brought back in line
with the original strategy. In strategic asset allocation, for
example, rebalancing is considered important because,
over time, some investments appreciate while others
depreciate, thereby altering the balance of the investment
portfolio from its intended longer-term target. In the
tactical, insured and integrated allocation approaches,
rebalancing is also the way in which changes in capital
market assumptions or the investor’s risk and return
preferences are incorporated into the portfolio.
With regard to the strategic asset allocation approach,
rebalancing mechanically forces investors to do exactly
the opposite of what their emotions would have them
do. Namely, it involves purchasing securities that have
underperformed and selling securities that have performed
well over the investment period. Rebalancing can
potentially help investors realize profits in an outperforming
asset class before it begins to underperform and increase This example is provided for illustrative purposes only and does not constitute
a recommendation or refer to any specific asset allocation strategy.
the weight to an underperforming asset class before it
The Rewards of Asset Allocation and Rebalancing Investment Solutions for Asset Allocation
Asset allocation and rebalancing play important roles in
achieving and maintaining diversified and disciplined For some, the cost of diversifying and maintaining a
investment portfolios. These relatively straightforward portfolio with individual securities can be prohibitively
investment strategies can provide investors with a number expensive. Fortunately, investors can use mutual funds,
of potential benefits: exchange-traded funds, unit investment trusts and
managed accounts for more cost-effective means of
Reduced Investment Risk – A diversified portfolio can achieving diversification.
experience reduced investment risk because the growth
opportunity is not limited to the performance of one Mutual funds in particular have become quite popular,
security, but is open to the opportunities presented by a particularly with individual investors. Mutual funds offer an
collection of securities. If one investment is doing poorly, easy and efficient way to implement and rebalance an
it will not compromise the entire portfolio. asset allocation strategy. With a modest amount of capital,
investors can achieve diversification by purchasing a single
Diminished Portfolio Volatility – Investing in a selection mutual fund that invests in the broad market, including
of securities spread across different asset classes can equity and fixed income investments. In addition, investors
provide a portfolio with the kind of diversification that may may purchase several mutual funds, representing a variety
help reduce volatility in turbulent times. The performance of asset classes to achieve their targeted asset allocation.
of the other securities in the portfolio can help to offset The rebalancing process can also be more timely and cost
the drop in price of a poorly performing security. A well- effective when dealing with a portfolio of mutual funds
diversified portfolio can provide investors with the versus numerous individual stock and bond securities.
opportunity for growth with less overall portfolio volatility.
Mutual funds can offer investors the following benefits:
Greater Investment Discipline – It is nearly impossible
to time the performance cycles of different investment • Professional Management – Mutual funds are
categories. Establishing an asset allocation strategy managed by experienced investment professionals.
and rebalancing regularly to preserve that strategy can
introduce more discipline into an investment plan. Having • Diversification – Money is often invested in a wide
a solid investment plan helps investors stick to their plans; variety of securities.
this in turn increases their chances of achieving their long-
term investment objectives. • Efficiency – Mutual funds are available to investors for
a modest initial investment, typically $1,000. For most
A Word of Caution – Asset allocation and rebalancing investors, mutual funds provide professional
alone do not guarantee profits, nor can they prevent losses management and diversification at a reasonable cost.
• Liquidity – Generally, fund shareholders can sell shares
at any time at that day’s closing net asset value.
• Convenience – Mutual funds offer investors easy access
to a wide range of securities. In addition, most mutual
fund companies offer shareholders a range of services,
including automatic investing and withdrawal programs,
reinvestment of fund distributions, and fund exchanges.
• Variety – Mutual funds are available in a wide variety Summary
of asset classes and styles, including:
• Diversification is a widely embraced investment strategy
– Money market funds that reduces risk and volatility in a portfolio.
– Short-term bond funds • A diversified portfolio contains a mix of securities from
each of the key asset classes: equity, fixed income and
– Intermediate-term bond funds cash-equivalent instruments.
– Long-term bond funds • There are several approaches to asset allocation, which
differ in their required levels of active management and
– High-yield bond funds assumptions about investors’ risk tolerances and about
changes in capital market expectations. These include:
– International fixed income funds
– Buy and Hold
– Global fixed income funds
– Balanced funds
– Growth stock funds
– Value stock funds
– International stock funds
• Determining a personal asset allocation plan depends on
– Global stock Funds an investor’s unique set of financial needs and goals.
– Emerging market Funds • Quantitative models, such as the portfolio optimization
model, use an investor’s return objective and risk
tolerance to determine a proposed mix of assets.
• Rebalancing helps preserve the asset allocation plan
• Asset allocation and rebalancing play important roles in
achieving diversified and disciplined investment
portfolios by helping to reduce investment risk and
portfolio volatility, and by improving investment
• Mutual funds can facilitate the implementation and
rebalancing of an asset allocation strategy by offering
investors professional management, diversification, cost
efficiency and variety.
Important Information to Consider When Investing
in Mutual Funds
Mutual funds involve investment risk, including the
possible loss of principal. Unlike bank deposits, mutual
funds are not insured or guaranteed by the FDIC or any
other government agency.
Additionally, each type of mutual fund has different types
of risk. For example, a fixed income fund is exposed to
interest rate risk, because as interest rates increase, the
prices of the bonds in the fund may decrease. Equity funds
are affected by changes in interest rates, general market
conditions and other political, social and economic
developments, as well as specific matters relating to the
companies whose stocks the portfolio includes. Investing
in international securities is subject to risks associated with
changes in currency values, economic, political and social
conditions, the regulatory environment of the countries
in which the fund invests, and the difficulties of receiving
current and accurate information.
Mutual funds are offered by prospectus only. Each mutual
fund’s prospectus includes complete information about
the investment objectives, risks, charges and expenses
associated with the fund. You should obtain a prospectus
from your Financial Advisor and read and consider this
information carefully before investing.