Asset Allocation

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What Is Asset Allocation? A basic decision that every investor must make is how to distribute his or her

investable funds amongst the various asset classes available in the marketplace:

Stocks (e.g., Large Cap, Small Cap) Fixed-Income (e.g., Government, Investment, High Yield) Cash Equivalents (e.g., T-bills) Alternative Assets (e.g., Private Equity, Hedge Funds) Real Estate (e.g., Residential, Commercial)

The Strategic allocation is the proportion of wealth the investor decides to place in each of these asset classes. It is sometimes also referred to as the investor’s long-term normal allocation because it is presumed to be the “baseline” allocation that will remain in place until the investor’s life circumstances change appreciably.

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Factors To Consider

Investment objective (e.g., retirement)

Time horizon for a goal (e.g., life expectancy for retirement)

Amount of money you have to invest

Your risk tolerance and experience

Your age and net worth

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Asset Allocation Strategies

Integrated asset allocationcapital market conditionsinvestor’s objectives and constraints

Strategic asset allocationconstant-mix

Tactical asset allocationmean reversioninherently contrarian

Insured asset allocationconstant proportion portfolio insurance

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Integrated Asset Allocation Model

C1 Capital Market Conditions

C2 Prediction Procedure

C3 Expected Returns, Risk

and Correlations

I1 Investor Assets, Liabilities

and Net Worth

I2 Investor's Risk Tolerance

Function

I3 Investor's Risk Tolerance

M1 Optimizer

M2 Investor's Asset Mix

M3 Returns

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Strategic asset allocationUsed to develop a long-term policy allocation

Example: Portfolio will always rebalance to revert to a :• 60% Stock• 30% Bond• 10% Cash allocation

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Tactical asset allocationUsed to develop short-term strategies to exploit changes in market

conditionsOften viewed as a contrarian strategy

Assume asset class performance is mean-reverting if stocks have performed above average relative to bonds,

underweight stocks and overweight bonds for next period

Assume stocks will generate above average returns overweight stocks!

Practical issues:

Frequency of rebalancingConstraints on “swing component”

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Insured asset allocation

Used to develop short-term strategies to exploit changes in investor’s objectives and constraints

This is a portfolio insurance strategyAssumes investors become more risk-tolerant as wealth

rises if stocks have performed above average relative to bonds, overweight

stocks for next periodAssumes investors become less risk-tolerant as wealth falls

If stocks have performed poorly, underweight in next periodPractical issues:

Frequency of rebalancingLiquidity

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Major Asset ClassesLarge company growth stocksLarge company value stocksSmall company growth stocksSmall company value stocksMid cap growth stocksMid cap value stocksForeign stocks

Developed Emerging

Bonds Domestic International

Real estate (e.g., REITs)Cash assets (e.g., Treasury bills)

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The Asset Allocation Process

Define goals and time horizon

Assess your risk tolerance

Identify asset mix of current portfolio

Create target portfolio (asset model)

Specific investment selection

Review and rebalance portfolio

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Key Considerations For Successful Investing

Establish policies and objectives

Stick to your plan and stay focused

Educate yourself to make informed decisions

Monitor investment performance

If you need help, seek a professional advisor

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