Investment Processes,

Asset Allocation
&
Portfolio Selection

Slide
Slide11

Comm 324 --- W. Suo

Objective
Investment process
Asset allocation
What portfolio will one choose among risky assets?
Two assets
General case
Efficient frontier
Spreadsheet examples

Slide
Slide22

Comm 324 --- W. Suo

Investment Process
Step 1: Create a Written Policy Statement

Gain Understanding

Expectations
The Policy Statement

Slide
Slide33

Investors financial situation

Investors time horizon
Investment goal(s)
Investors tax situation
Legal constraints
Liquidity
Personal inventory

Objective
Benchmark
Constraint policies
Asset allocation policies

Comm 324 --- W. Suo

Investment Process
Step 2: Forecasting

Fundamental analysis
Technical analysis
Risk-Return analysis

Step 3: Allocating Assets

Slide
Slide44

If no constraints, asset allocation is accomplished, the asset

allocators responsibility is to align portfolios expected return and
risk with the clients goal
Constrained asset allocation
Asset allocator must examine the make-up of the portion of the
portfolio that is subject to constraints prior to allocating the nonconstrained portion

Comm 324 --- W. Suo

Investment Process

Investing the Allocated Funds

May be a simple or more complicated task
Do old assets need to be liquidated?
Are large transactions involved?

Step 4: Performance Reports and Feedback

Measures?
Quarterly reports
Potential problems

Slide
Slide55

Comm 324 --- W. Suo

Asset allocation
Objective:

Determining the mixture of securities that is most likely

to provide an optimal combination of expected return and
risk for the investor

Studies have shown that over 90% of variation from

typical portfolios can be explained by asset
allocation.

Slide
Slide66

Where one invests is very important!

Comm 324 --- W. Suo

Examples
Portfolio 1: 50-50 allocation between stocks and bonds
Portfolio 2: 60-40 allocation between stocks and bonds
Portfolio 3: 20-60-20 allocation between real estate, stocks
and bonds
Portfolio 4: 10-40-20-30 allocation between real estate,
domestic stocks, foreign stocks, and bonds

Example: Queens Pension Fund
http://
www.queensu.ca/humanresources/total-compensation/pensions/
reports
Slide
Slide77

Comm 324 --- W. Suo

Examples
T. Rowe Price Non-Retirement goals Matrix

Cash

Bonds

Stocks

Strategy1

30

50

20

Strategy2

20

40

40

Strategy3

10

20

60

Strategy4

20

80

Strategy5

100

RiskTolerance

TimeHorizon

3-5 Years

6-10 Years

11+ Years

High

Strategy 2

Strategy 3

Strategy 5

Moderate

Strategy 1

Strategy 2

Strategy 4

Lower

All Cash

Strategy 1

Strategy 3

Slide
Slide88

Comm 324 --- W. Suo

Different Asset Allocations

Strategic asset allocation (SAA)

Used to derive long-term asset allocation weights

These weights are not changed when capital markets change

Tactical asset allocation (TAA)

Used to derive temporary weights used in response to

temporary changes in capital market weights

Passive allocation will not have TAA weights

Quantitative methods are also used sometimes in

asset allocation

Slide
Slide99

Example will be given later

Comm 324 --- W. Suo

Portfolio Mathematics
Two risky assets case

Risk-free and risky asset

Three assets case

Spreadsheet example

General case

Slide
Slide10
10

Spreadsheet example

Comm 324 --- W. Suo

Combining risk assets

What happens if we choose a portfolio by combing
risky assets

Two asset case

Example: For 20% in 1 and 80% in 2

Expected return 11.60%
Variance 0.01512
Standard deviation 0.1230

Slide
Slide11
11

General case

Comm 324 --- W. Suo

Assets

Return STD rho

1
18% 30% -0.2
2

10%

15%

Two-Security Portfolios
with Different Correlations

Slide
Slide12
12

Comm 324 --- W. Suo

Portfolio of Two Securities:

Correlation Effects
Relationship depends on correlation coefficient
-1.0 < < +1.0
The smaller the correlation, the greater the risk
reduction potential
If= +1.0, no risk reduction is possible

Slide
Slide13
13

Comm 324 --- W. Suo

Optimal Risky Portfolio with

Two Risky Assets
Suppose our investment universe comprises the two
securities

Risk free rate: 5%

Slide
Slide14
14

Comm 324 --- W. Suo

The Opportunity Set of the Debt and Equity

Funds and Two Feasible CALs

Slide
Slide15
15

Comm 324 --- W. Suo

Optimal CAL and the Optimal Risky

Portfolio

Slide
Slide16
16

Comm 324 --- W. Suo

Determination of the Optimal Overall

Portfolio

Slide
Slide17
17

Comm 324 --- W. Suo

Final Portfolio

Spreadsheet
Between

Risk free
Risk portfolio:

Assume an investors risk aversion

Final portfolio:

Slide
Slide18
18

Risk free: 25.61%

In Debt: 74.39%*40%=29.76%
In equity: 74.39%*60% = 44.63%

Comm 324 --- W. Suo

Extending Concepts to All

Securities
The optimal combinations result in lowest level of risk for a given
return
The optimal trade-off is described as the efficient frontier
These portfolios are dominant
Spreadsheet example

Slide
Slide19
19

Comm 324 --- W. Suo

Extending to Include A Riskless Asset

The set of opportunities again described by the CAL
The choice of the optimal portfolio depends on the
clients risk aversion
A single combination of risky and riskless assets
will dominate

Slide
Slide20
20

Comm 324 --- W. Suo

Alternative CALs
E(r)

CAL (P)

CAL (A)

M
P

P
A

CAL (Global
minimum variance)

A
G

Slide
Slide21
21

Comm 324 --- W. Suo

Portfolio Selection & Risk Aversion:

without borrowing/lending
E(r)

U U U

P
Q
More
risk-averse
investor
Slide
Slide22
22

Comm 324 --- W. Suo

Efficient
frontier of
risky assets
Less
risk-averse
investor

Portfolio Selection & Risk Aversion:

with borrowing/lending
E(r)

CAL

B
Q
P
A

rf

Slide
Slide23
23

Comm 324 --- W. Suo

Example: Asset Allocation

Country Index Statistics

Optimal allocation:

Slide
Slide24
24

US

UK

FRA

GER

Aus

JAP

CAD

0.69

0.05

0.00

0.00

0.13

0.13

0.00

Comm 324 --- W. Suo

Portfolio Selection & Risk Aversion:

with borrowing/lending
With different borrowing/lending rate?

Slide
Slide25
25

Comm 324 --- W. Suo