Quick Answer
Strategic asset allocation sets long-term target weights from a client's goals, risk tolerance, and time horizon, then rebalances back to those targets (calendar-based or threshold-based) as markets drift. Tactical allocation deliberately deviates from those targets for short-term opportunities via market timing and sector rotation, typically at higher cost and with no guarantee of success.
Asset allocation strategies provide the blueprint for how a portfolio is structured. Before choosing individual securities, an adviser must decide on the overall mix of asset classes and how rigidly to stick to that mix over time.
Strategic Asset Allocation
Strategic asset allocation is the long-term approach to portfolio construction. It sets target percentage weights for each asset class based on three client-specific factors:
- Goals: What the client needs the portfolio to accomplish (retirement, education, wealth preservation)
- Risk tolerance: How much volatility the client can accept
- Time horizon: How long before the client needs the money
A typical strategic allocation might look like: 60% stocks, 30% bonds, 10% cash.
The key principle: once targets are set, you stick with them through market ups and downs. The target allocation itself only changes when the client's circumstances change, not because of short-term market movements; the portfolio's actual holdings still shift with rebalancing as markets drift.
Rebalancing
Over time, market movements cause the actual portfolio to drift from its targets. If stocks outperform bonds, a 60/40 portfolio might become 70/30. Rebalancing is the process of bringing the portfolio back to its target weights, typically by selling the overweight asset class and buying the underweight one, though it can also be done by directing new contributions toward the underweight class without any sales.
There are two main rebalancing approaches:
| Method | How It Works | Trade-Off |
|---|---|---|
| Calendar-based | Rebalance at fixed intervals (quarterly, annually) | Simple and disciplined, but may miss large drifts between dates |
| Threshold-based | Rebalance when any asset class drifts beyond a set percentage (e.g., +/- 5%) | More responsive to market moves, but may trigger more frequent trades |
When rebalancing involves sales, it enforces a natural "buy low, sell high" discipline: trimming what has gone up and adding to what has gone down.
Think of it this way: Rebalancing is like pruning a garden. When one plant grows too tall and crowds the others, you trim it back and give the smaller plants more room. The portfolio stays balanced, and you are systematically selling high and buying low.
Buy and Hold
Buy and hold is the simplest form of strategic allocation. The investor purchases securities and holds them for the long term regardless of short-term market fluctuations.
- Typically minimizes transaction costs, and defers or reduces realized capital gains taxes in a taxable account
- Relies on the belief that markets rise over the long term
- Suits investors with long time horizons; the risk depends on what is held, not on the strategy itself
- Does not involve active rebalancing (unlike strategic allocation with rebalancing targets)
Exam Tip: Gotchas
- Buy and hold does NOT guarantee profits. It is a passive strategy that typically minimizes costs, but the portfolio can still lose value if markets decline.
Tactical Asset Allocation
Tactical asset allocation takes a different approach. Instead of maintaining fixed targets, the adviser makes short-term deviations from the strategic allocation to capitalize on perceived market opportunities.
- Involves market timing and sector rotation (shifting money toward sectors expected to outperform)
- Typically more active and potentially higher cost than strategic allocation
- Typically generates more taxable events in a taxable account due to more frequent trading
- Requires correct market forecasting to add value, and research shows this is very difficult to do consistently
Exam Tip: Gotchas
- Rebalancing is NOT the same as tactical allocation. Rebalancing brings the portfolio back to its original targets after market drift. Tactical allocation deliberately moves away from targets to exploit short-term opportunities, then returns to the strategic allocation once the opportunity passes.
Strategic vs. Tactical: Side by Side
| Feature | Strategic | Tactical |
|---|---|---|
| Time horizon | Long-term | Short-term |
| Basis for changes | Client circumstances change | Market conditions change |
| Trading frequency | Typically low (periodic rebalancing) | Typically higher (active adjustments) |
| Costs | Typically lower fees; typically lower taxes in a taxable account | Typically higher fees; typically higher taxes in a taxable account |
| Skill required | Discipline to stay the course | Accurate market forecasting |
What Should You Check on Exam Day?
- Strategic allocation sets long-term targets based on the client's goals, risk tolerance, and time horizon, and only changes when the client's circumstances change.
- Rebalancing brings the portfolio back to its existing targets; tactical allocation deliberately moves away from targets to chase short-term opportunities. Do not confuse the two.
- The two rebalancing methods are calendar-based (fixed intervals) and threshold-based (drift beyond a set percentage).
- Buy and hold typically minimizes transaction costs and defers or reduces realized capital gains taxes in a taxable account, but does not guarantee a profit.
- Tactical allocation is typically more active, typically generates more taxable events in a taxable account, and requires market forecasting that is difficult to do consistently.