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Hong KongAsset allocation: the decision that dominates everything after it
Strategic allocation sets long-term target weights from the client's goals, horizon and risk tolerance. Rebalancing returns the portfolio to those weights, triggered either by a calendar or by a percentage band around each target.
The allocation decision governs most of the variability in portfolio outcomes, which is why questions spend more time on it than on security selection.
The inputs
- Time horizon. How long until the money is needed, and over what period it is spent.
- Risk tolerance. Willingness to accept volatility.
- Risk capacity. Ability to absorb loss without derailing the goal - a different thing from tolerance.
- Required return. What the goal actually needs.
- Liquidity needs. Known near-term calls on capital.
- Tax position. Which accounts hold what.
- Constraints. Concentrated positions, restricted stock, legacy holdings, client preferences.
Tolerance and capacity being different is the distinction questions use. A client comfortable with volatility who cannot afford to lose the money has high tolerance and low capacity, and capacity wins.
Strategic, tactical, dynamic
| Approach | What it does |
|---|---|
| Strategic | Long-term target weights, held through cycles |
| Tactical | Short-term deviations from target to exploit expected mispricing |
| Dynamic | Systematic shifts as circumstances change, such as glide paths |
| Core and satellite | A passive core with active or specialist satellites |
Strategic is the default recommendation. Tactical requires a defensible view about relative value and a discipline for returning to target, and questions describing a planner chasing recent performance are describing something else.
Rebalancing triggers
Calendar: review at a fixed interval, annually or semi-annually. Simple, and it can miss large intra-period moves.
Percentage bands: rebalance when an asset class moves more than a set amount from target, in absolute or relative terms. More responsive, and more transactions.
Hybrid: review on a calendar and act only if a band has been breached. That is what most practitioners actually do.
It means selling what has done well and buying what has not. That is the point - it enforces buying low and selling high against every behavioral instinct, which is why it needs to be a written policy rather than a judgment call.
Doing it tax efficiently
- Rebalance inside tax-deferred accounts first - no tax consequence.
- Direct new contributions to the underweight asset class.
- Direct distributions and dividends rather than reinvesting them automatically.
- In taxable accounts, harvest losses alongside gains.
- Consider donating appreciated holdings to charity instead of selling them.
The first two do most of the work and cost nothing, which is why a question about rebalancing a portfolio spread across account types usually wants the tax-deferred account named.
Dollar limits and rate thresholds here are indexed annually. Confirm the current figure before relying on it, and expect the exam to test the rule rather than the number.
Common questions
What determines a client's asset allocation?
Time horizon, risk tolerance, risk capacity, required return, liquidity needs, tax position and any constraints such as concentrated or restricted holdings.
What is the difference between risk tolerance and risk capacity?
Tolerance is willingness to accept volatility; capacity is ability to absorb loss without derailing the goal. Where they conflict, capacity governs.
What is the difference between strategic and tactical allocation?
Strategic sets long-term target weights held through cycles. Tactical makes short-term deviations to exploit expected mispricing and needs a discipline for returning to target.
How often should a portfolio be rebalanced?
Either on a calendar, annually or semi-annually, or when an asset class breaches a percentage band around its target. Most practitioners review on a calendar and act only on a breach.
How do you rebalance tax efficiently?
Inside tax-deferred accounts first, then by directing new contributions and distributions to the underweight class. In taxable accounts, harvest losses alongside gains.