A portfolio can hold good investments and still expose a client to the wrong risks. Your strategy connects each holding to the client's spending needs and investment horizon.
Before choosing securities, determine how much money belongs in stocks, bonds and cash. These broad investment categories are asset classes. Strategic asset allocation sets their long-term target weights around the client's objectives, risk tolerance, time horizon and constraints.
Risk tolerance describes the client's willingness and ability to bear losses. Time horizon is the period before money is needed. Constraints include taxes, cash needs and restrictions on investments. A client needing tuition next year cannot evaluate stock losses like someone investing for retirement decades away.
Market movements change portfolio weights even without trading. Rebalancing restores the strategic asset allocation on a schedule or when weights exceed tolerance bands, the permitted deviations from targets. It usually reduces overweight holdings and adds to underweight holdings.
Suppose stocks rise to $70,000 while bonds remain $40,000. Total value is $70,000 + $40,000 = $110,000. At a 60% stock target, stocks should equal $110,000 × 0.60 = $66,000.
Common mistakes
- Calling a forecast-driven reduction from 60% stocks to 45% routine rebalancing. The changed target identifies tactical asset allocation.
- Treating a price-to-earnings ratio of 8 as proof of value. Investigate deteriorating earnings before treating the discount as an opportunity.
- Using $23.33 from Example 1 as average cost. The correct denominator is 42 shares, producing $21.43.
Bottom line
- Strategic allocation sets long-term weights; rebalancing restores them after drift.
- Tactical allocation and sector rotation rely on forecasts and add timing risk.
- Active management seeks outperformance; passive management seeks index tracking.
- Growth and value styles can both support capital appreciation.
Exam shortcut
Identify the decision first: choosing target weights, restoring them, or changing them because of a forecast. Then match the strategy label. For dollar-cost averaging, calculate shares at each price before totaling anything. Reject an answer built only from averaging prices. For options, mark who owns the right and who owes performance. Then check whether the seller already owns the underlying stock.
The full lesson (about 3,416 words, 23 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- C12
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