Aurora Borealis
1 January 1995 Financial Analysts Journal Volume 51, Issue 1

Dynamic Strategies for Asset Allocation

  1. André F. Perold
  2. William F. Sharpe

As risky assets (e.g., stocks) fluctuate in value, the value of a portfolio containing them may change, as may their allocation relative to the safe assets (e.g., bills) within the portfolio. One must decide how to rebalance the portfolio in response to such changes. Dynamic strategies are explicit rules for doing so. Different strategies will produce different risk and return characteristics. Buy-and-hold strategies are "do nothing" strategies. They have a minimum return proportional to the amount allocated to bills and an upside proportional to the amount allocated to stocks. Their performance is linearly related to the performance of the equity market. Strategies that sell stocks as the market falls and buys stocks as the market rises represent the purchase of portfolio insurance. Particular examples are constant-proportion portfolio insurance and option-based portfolio insurance. These strategies have better downside protection and better upside potential than buy-and-hold strategies. They do worse in relatively trendless, volatile markets. Constant-mix strategies—holding a constant fraction of wealth in stocks—buy stocks as the market falls and sell them as it rises. These and other such strategies effectively represent the sale of portfolio insurance. They have less downside protection than, and not as much upside as, buy-and-hold strategies. They do best in relatively trendless but volatile markets. The greater the "popularity" of one type of strategy—be it the purchase or sale of portfolio insurance—the more costly it becomes and the greater the rewards to those who follow the opposite strategy. Only buy-and-hold strategies can be followed by all investors.

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