Portfolio Allocation, Diversification and Rebalancing


Two of the most important decisions an investor must make when constructing portfolios are 1) allocation of the portfolio assets between stocks, bonds, cash and other investments and 2) diversification of securities within those asset classes.

These decisions will not only determine the risk character of the portfolio, but they will also provide the major explanation for the portfolio’s return. There are four concepts that help better understand the relationship between allocation and diversification. These are the strategic asset allocation of the portfolio, the tactical asset allocation of the portfolio, portfolio rebalancing, and portfolio diversification.

Strategic vs. Tactical Allocation

Strategic Asset Allocation

This allocation refers to the long-term plan to combine portfolio assets. These assets are combined in a manner that is suitable for an investor’s risk tolerance. In other words, strategic allocation answers how much of the portfolio should be invested in bonds vs. stocks vs. cash.

Investors strive to the achieve the highest rate of return for the level of risk assumed. Because of this, there are several important risk factors that are considered when forming strategic allocation decisions.  These include the investor’s appetite for risk: market volatility risk (beta), the estimated inflationary risk (purchasing power risk) and the investor’s liquidity risk (unanticipated need for cash). Once identified, then the portfolio’s normal “target” balances of each asset class are assigned. These targets serve as the portfolios long-term “preferred” asset mix, and are therefore infrequently changed. To summarize, strategic asset allocation refers to the asset mix – i.e., % stocks, bonds, cash, etc. It should be based on current market conditions and the investors’ objectives, needs and risk tolerance. Many studies have shown strategic asset allocation is the predominant determinant of an investor’s return.

Tactical Asset Allocation

Tactical allocation on the other hand refers to the short-term allocation decisions made in order to take advantage of current market conditions. Tactically, an actively managed portfolio will be constantly adjusted. This is to take advantage of perceived relative values between the assets classes. So, if the investor believes that stocks are undervalued relative to bonds, funds would be shifted from bonds into stocks to take advantage of those current market conditions.

Tactical asset allocation decisions are driven by judgments of relative values between asset classes and are based on mean reversion. Examples are asset classes that are under or overvalued will move toward normal value so opportunity to profit exists.


Portfolio Diversification

Equally important is adequate portfolio diversification. Diversification not only relates to the asset mix of the portfolio, but also relates to the individual securities held within each asset class. In other words, a portfolio with a strategic allocation mix of 30% bonds, 60% stocks, and 10% cash may seem adequately diversified. However, if the common stock percentage is overly concentrated in large cap stocks, or high technology companies, the overall risk of the portfolio will be greater than it if more widely diversified by company size (small, medium, large) and industry sectors (energy, healthcare, industrial, etc.).  Successful investors keep a close eye on the diversification of their investments within their portfolio allocations. The goal is to maximize return for the risk assumed.


Portfolio Rebalancing

Finally, once the allocation and diversification targets are set, investors need to monitor their portfolio. This is to gauge how current market valuations are impacting goals and to identify if rebalancing is required.  Portfolio rebalancing refers to the shifting of portfolio funds between the portfolio assets due to the relative performance between the assets. Investment funds may be reallocated from over-performing assets into under-performing assets. This is to better align the long-term strategic target portfolio weights.  If an investor is pursuing short-term tactical allocation, rebalancing enables the investor to take advantage of current market conditions.


The benefits of sound portfolio allocation planning are many. Focusing on these important concepts of portfolio management helps to prevent overly concentrated portfolios and to reduce overall portfolio risk. It also adds discipline to the management process and helps to avoid emotional decision making.

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