Home › CFA® Level III › Asset Allocation
CFA® Level III · Asset Allocation · free lesson
Asset Allocation with Real-World Constraints
A textbook allocation must survive real investors: their size, their need for cash, their horizon, their regulators and their tax bills, and the fact that their circumstances and their judgment change over time. This module adapts the strategic allocation to these constraints, shows how to work with after-tax returns and risk, explains when an allocation should be revised, evaluates tactical departures from the strategic mix, and identifies the behavioral biases that distort allocation decisions together with practical ways to counter them.
What you will learn
1. Adapt a strategic asset allocation to the investor's asset size, liquidity needs, time horizon and regulatory constraints.
- Large investors gain scale economies but face market impact and capacity limits; small investors struggle with minimum commitments and governance resources.
- Liquidity planning must cover spending, capital calls, collateral and redemptions in a stress scenario.
- Long horizons allow more illiquid and volatile assets, but horizons shorten with age and with plan closure.
- Regulation (capital charges, funding rules, distribution requirements) often binds the allocation hardest.
- Find the best feasible allocation and make the cost of each constraint visible to the governing body.
2. Incorporate taxes into asset allocation and rebalancing decisions using after-tax returns, after-tax risk and asset location.
- After-tax return = r(1 - t) when fully taxed; mixed returns are taxed component by component, and deferral adds value.
- With symmetric taxation of gains and losses, after-tax volatility is roughly sigma(1 - t).
- Measure allocations on after-tax values: a tax-deferred account is worth its balance times (1 - t).
- Locate tax-inefficient assets in tax-deferred accounts and tax-efficient assets in taxable accounts.
- Taxable investors use wider rebalancing corridors (about R / (1 - t)) and harvest losses.
3. Recommend revisions to a strategic asset allocation when the investor's objectives, constraints or capital market expectations change.
- Review the SAA regularly and when goals, constraints, beliefs or funded status change materially.
- Liquidity events, retirement, plan freezes and structural shifts in yields are classic triggers.
- Glide paths raise the hedge ratio as the funded ratio improves.
- Market moves alone call for rebalancing, not a new strategic allocation.
- Plan transitions for costs, taxes and the time needed to change illiquid holdings; phase in or use derivatives.
4. Evaluate tactical asset allocation and other short-term departures from the strategic asset allocation.
- TAA is a temporary, deliberate tilt within IPS ranges; a change in SAA is permanent and follows a change in long-term inputs.
- Signals: valuation, business cycle, momentum, carry, sentiment; discretionary or systematic.
- TAA needs a risk budget (tracking error versus the SAA) and a clear decision process.
- Evaluate with the return contribution after costs, Sharpe ratios of TAA versus SAA and the information ratio.
- A gain from simply adding beta in a rising market is not evidence of skill.
5. Identify behavioral biases that distort asset allocation decisions and recommend ways to counter them.
- Loss aversion: too conservative, reluctant to rebalance into losers; counter with goals-based framing and pre-set rules.
- Illusion of control and overconfidence: excessive trading and concentration; counter with the market portfolio as a starting point and risk budgets.
- Mental accounting can be harnessed by goals-based allocation, but total portfolio risk must still be checked.
- Recency and representativeness lead to performance chasing; framing changes choices; familiarity drives home bias.
- Governance (IPS, rebalancing rules, diverse committees, documented decisions) is the main institutional defence.
Module at a glance
- Size brings scale economies and capacity limits; small investors are constrained by minimum commitments and governance resources.
- Plan liquidity for spending, capital calls and collateral under stress; regulation often binds the allocation hardest.
- Use after-tax returns, after-tax risk and after-tax values; locate tax-inefficient assets in tax-deferred accounts.
- Taxable investors widen rebalancing corridors (about R / (1 - t)) and harvest losses.
- Revise the SAA when goals, constraints, expectations or funded status change; rebalance when only prices move.
- Judge TAA against the SAA on a risk-adjusted basis after costs; extra beta is not skill.
- Counter loss aversion, overconfidence, recency, framing and home bias with governance and pre-set rules.
This free module has 5 lessons, 18 practice questions with full explanations and 1 essay case with a model answer.