Module 7: Asset Allocation
Asset Allocation is the process of distributing investments across different asset classes to achieve an optimal balance between risk and return.
In CFA Level 3, asset allocation is the core of portfolio management, as it determines the majority of a portfolio’s performance.
Portfolio managers use asset allocation to:
- align investments with client objectives
- manage risk effectively
- optimize long term returns
This module focuses on strategic, tactical, and risk based approaches to asset allocation.
Strategic Asset Allocation is a long term approach to portfolio construction.
It involves setting target allocations to different asset classes based on:
- investor goals
- risk tolerance
- time horizon
Long Term Portfolio Design
Portfolio managers design long term portfolios by allocating assets such as:
- equities
- fixed income
- alternative investments
Example Allocation
- 60 percent equities
- 30 percent bonds
- 10 percent alternatives
This allocation is based on expected returns and risk levels over the long term.
Key Characteristics
- stable and disciplined approach
- based on long term market expectations
- requires periodic rebalancing
Importance
Strategic allocation forms the foundation of portfolio construction and is responsible for most of the portfolio’s return.
Tactical Asset Allocation involves making short term adjustments to portfolio weights based on market conditions.
Short Term Adjustments
Portfolio managers may temporarily deviate from strategic allocation to take advantage of:
- market opportunities
- economic trends
- valuation differences
Example
- increasing equity exposure during economic expansion
- shifting to bonds during market uncertainty
Key Characteristics
- flexible and active approach
- based on short term forecasts
- aims to enhance returns
Risks
- incorrect market timing may reduce returns
- higher transaction costs
Risk based allocation focuses on distributing risk rather than capital across asset classes.
This approach ensures that each asset contributes proportionally to overall portfolio risk.
Risk Parity Approach
Risk parity is a popular risk based allocation method.
Key Concept
Instead of allocating equal capital, the goal is to allocate equal risk contribution across assets.
Example
- equities are more volatile, so lower capital allocation
- bonds are less volatile, so higher capital allocation
Benefits of Risk Parity
- improved diversification
- balanced risk exposure
- more stable portfolio performance
Limitations
- requires accurate risk estimation
- may involve leverage
- sensitive to changing market conditions
Strategic Allocation
Long term and stable approach
Tactical Allocation
Short term and flexible approach
Risk Based Allocation
Focus on balancing risk rather than capital
Portfolio managers often combine these approaches to achieve optimal results.
Asset allocation is one of the most important topics because it helps candidates:
- design efficient portfolios
- manage risk effectively
- align investments with objectives
- apply macroeconomic views
In CFA Level 3, many essay questions are based on asset allocation, making this a high scoring and must master module.