Asset Allocation

Exam items hand you a scenario and ask which portfolio-construction step comes first or drives the most variability: the answer is almost always the asset-allocation policy, ahead of security selection or market timing. A common vignette gives an investor’s objectives and constraints (the IPS inputs) and asks what they feed — the strategic (policy) allocation, not individual security picks. The “tell” for a tactical question is language about short-run views or temporary mispricing; the tell for rebalancing is returning to target weights — neither a new active bet nor a change to the policy.

The classic trap is conflating asset allocation with diversification: allocation chooses which asset classes and their weights, while diversification lowers risk by combining less-than-perfectly-correlated holdings (it trims unsystematic risk but cannot remove systematic risk). Another: treating tactical shifts and rebalancing as the same — tactical deliberately deviates from policy, rebalancing restores it. Memory hook: allocation answers “how much in each bucket,” diversification answers “how uncorrelated is what’s inside.”