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Constant Weight Asset Allocation

A type of asset allocation approach in which rebalancing occurs automatically

What is Constant Weight Asset Allocation?

Constant weight asset allocation can be defined as a type of asset allocation approach in which rebalancing occurs automatically. Several mutual funds permit rebalancing when they are established.

 

Constant Weight Asset Allocation

 

For example, if an investor holds a portfolio amounting to about 70% stock in the US, 20% stock on the international market, while the rest is taken up by bonds and the value surges to 35% by value of stock, the fund would act quickly to rebalance by disposing international stock and acquiring bonds.

Most investors prefer such an approach because their stocks are always protected against the slow response to market trends. As is the case with strategic asset allocation, an investor may not realize gains enjoyed by others; however, he will remain protected against loss.

 

Constant Weight and Asset Rebalancing

Whether an investor chooses to focus on fine wines or stocks, the rule remains the same when one is formulating investment strategies. The rule is that an investor will most like need to employ constant weight asset allocation as a strategy.

Although the fundamental asset allocation process works on the principle of buy and hold, it makes much sense to set aside some time and undertake a review of the portfolio with the intent to rebalance when the need arises.

An investor should take a long-term view in order to get the best outcome. However, frequent rebalancing goes a long way towards enhancing the percentage of return achieved. In the event that the value of a given asset is depreciating, but there is confidence that it will become profitable in the long term, rebalancing would involve acquiring more of the same asset to profit more.

The strategy works on the conjecture that it is possible to maximize returns by “buying the dip,” a common phrase in stock trading, and then selling when there is a sign of rallying.

Constant weighting, together with a measure of rebalancing, involves capitalizing on opportunities in order to lock in as much profit as possible buy disposing assets when a target level is achieved.

 

Periodic Asset Rebalancing

Two methods can be used in asset rebalancing. An investor can simply check the allocation over a specific interval, say monthly or yearly. Obviously, an investor who does such a thing on a regular basis won’t stand the risk of straying from the most preferred allocation objective.

However, even when an investor checks assets on a regular basis, periodic asset allocation doesn’t always account for issues such as market swings. If the rebalancing takes place on the first day of stock market trading, an investor can easily go out of control in case there is a 20% fall on the market.

 

Risk Threshold Asset Rebalancing

The risk threshold rebalancing method makes use of the risk threshold rather than periodic intervals. Instead of looking at the existing portfolio and rebalancing every time, the risk threshold method only performs a rebalance whenever the need arises. A risk threshold is also known as a tolerance band because an investor will need to tolerate a small amount of stray from.

In principle, the risk threshold method is ideal when there is support from technology. Very few investors would want to spend their time monitoring portfolios in order to ensure there isn’t unwarranted drift. Risk rebalancing works really well with automated mechanisms that monitor portfolio performance and can issue alerts when deviations arise.

 

Combined Asset Rebalancing

Another very popular approach to asset rebalancing is the use of combined portfolio management. The combined method uses both risk and periodic rebalancing. That way, the investor reviews the portfolio regularly but rebalances only when assets seem to be straying from the intended allocation framework. Most investors favor such a method because it works really well when assets involve transaction costs.

Most asset traders work with commissions where the stock, ETFs, and bonds are involved. Others work with load charges or redemption costs. It means that the asset rebalancing will incur some kind of cost. For that reason, an investor should weight and find out if the cost outweighs benefits during rebalancing.

 

Infrequent Rebalancing

An important question to consider is what might happen in case an investor doesn’t perform regular rebalancing. Well, with time, greater asset/risk profits would out-compound lesser risk/return portfolio classes, leading to a shift to equities.

For example, an investor who started with 40% bonds and 60% stocks with a potential 5% return from bonds and a 10% return from stock would end up with more stock than bonds. Why? The stock would grow much faster than the bonds, and with time, it would form a greater portion of the assets.

 

Final Word

Proper asset management requires the best rebalancing strategy, particularly one that aligns an investor’s portfolio with the allocation target. That way, it makes it easy for the asset manager to check risks as regularly as possible. However, it is important not to overdo it to the point that assets are disposed of before they appreciate to their highest level.

 

Related Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Diversification
  • Dynamic Asset Allocation
  • Investment Policy Statement (IPS)
  • Investing: A Beginner’s Guide

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