Benefits Of Asset Allocation & Rebalancing

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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.

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Benefits Of Asset Allocation & Rebalancing

  1. 1. Fundamentals 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 investment strategy. 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.
  2. 2. 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. 2 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. 2
  3. 3. 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 Risk Tolerance 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 3
  4. 4. 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 4
  5. 5. The Rewards of Asset Allocation and Rebalancing Investment Solutions for Asset Allocation and Rebalancing 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. in portfolios. • 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. 5
  6. 6. • 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 – Insured – Balanced funds – Strategic – Growth stock funds – Tactical – Value stock funds – Integrated – 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 over time. • 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 discipline. • Mutual funds can facilitate the implementation and rebalancing of an asset allocation strategy by offering investors professional management, diversification, cost efficiency and variety. 6
  7. 7. 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. 7
  8. 8. ©2005 UBS Financial Services Inc. All Rights Reserved. Member SIPC. ab UBS Financial Services Inc. www.ubs.com/financialservicesinc 041229-2100-S342 UBS Financial Services Inc. is a subsidiary of UBS AG.

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