Investment Processes,

Asset Allocation
&
Portfolio Selection

Slide 1 Comm 324 --- W. Suo

 Objective

w
Investment process
w
Asset allocation
w
What portfolio will one choose among risky assets?
n Two assets

n General case

n Efficient frontier

n Spreadsheet examples

Slide 2 Comm 324 --- W. Suo

 Investment Process

w
Step 1: Create a Written Policy Statement
n Gain Understanding
l Investor’s financial situation
l Investor’s time horizon
l Investment goal(s)
l Investor’s tax situation
l Legal constraints
l Liquidity
l Personal inventory
n Expectations
n The Policy Statement
l Objective
l Benchmark
l Constraint policies
l Asset allocation policies

Slide 3 Comm 324 --- W. Suo

 Investment Process …

w
Step 2: Forecasting
n Fundamental analysis
n Technical analysis
n Risk-Return analysis
w
Step 3: Allocating Assets
n If no constraints, asset allocation is accomplished, the asset allocator’s responsibility is to align
portfolio’s expected return and risk with the client’s goal
n Constrained asset allocation
n Asset allocator must examine the make-up of the portion of the portfolio that is subject to
constraints prior to allocating the non-constrained portion
n Investing the Allocated Funds
l May be a simple or more complicated task

l Do old assets need to be liquidated?

l Are large transactions involved?

w
Step 4: Performance Reports and Feedback
n Measures?
n Quarterly reports
n Potential problems
Slide 4 Comm 324 --- W. Suo
 Asset allocation
w
Objective:
n Determining the mixture of securities that is most likely to provide an optimal
combination of expected return and risk for the investor
w
Studies have shown that over 90% of variation from typical portfolios can be
explained by asset allocation.
n Where one invests is very important!
w
Examples
n Portfolio 1: 50-50 allocation between stocks and bonds
n Portfolio 2: 60-40 allocation between stocks and bonds
n Portfolio 3: 20-60-20 allocation between real estate, stocks and bonds
n Portfolio 4: 10-40-20-30 allocation between real estate, domestic stocks, foreign stocks, and
bonds
w
Strategy 1
T. Rowe
Cash
Price
30
Non-Retirement
Bonds
50
Stocks
goals
20
Matrix
Risk Tolerance Time Horizon

Strategy 2 20 40 40 3-5 Years 6-10 Years 11+ Years

Strategy 3 10 20 60 High Strategy 2 Strategy 3 Strategy 5
Strategy 4 0 20 80 Moderate Strategy 1 Strategy 2 Strategy 4
Strategy 5 0 0 100 Lower All Cash Strategy 1 Strategy 3

Slide 5 Comm 324 --- W. Suo

 Different Asset Allocations

w
Strategic asset allocation (SAA)
n Used to derive long-term asset allocation weights
l These weights are not changed when capital markets change
w
Tactical asset allocation (TAA)
n Used to derive temporary weights used in response to temporary changes in
capital market weights
l Passive allocation will not have TAA weights
w
Quantitative methods are also used sometimes in asset allocation
n Example will be given later
w
See
n Queen’s Pension Policy
n Queen’s Pension Quarterly Report

Slide 6 Comm 324 --- W. Suo

 Portfolio Mathematics

w
Two risky assets case
n Risk-free and risky asset
w
Three assets case
n Spreadsheet example

w
General case
n Spreadsheet example

Slide 7 Comm 324 --- W. Suo

 Combining risk assets

w
What happens if we choose a portfolio by combing
risky assets
Assets
n Two asset case Return STD rho
l Example: For 20% in 1 and 80% in 2 1 18% 30% -0.2
w Expected return 11.60% 2 10% 15%
w Variance 0.01512
w Standard deviation 0.1230
n General case

Slide 8 Comm 324 --- W. Suo

 Two-Security Portfolios
with Different Correlations

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

Slide 9 Comm 324 --- W. Suo

 Optimal Risky Portfolio with
Two Risky Assets
w
Suppose our investment universe comprises the two
securities

w
Risk free rate: 5%

Slide 10 Comm 324 --- W. Suo

 The Opportunity Set of the Debt and Equity
Funds and Two Feasible CALs

Slide 11 Comm 324 --- W. Suo

 Optimal CAL and the Optimal Risky
Portfolio

Slide 12 Comm 324 --- W. Suo

 Determination of the Optimal Overall
Portfolio

Slide 13 Comm 324 --- W. Suo

 Final Portfolio

w
w Spreadsheet
w
Between
n Risk free
n Risk portfolio:
w
Assume an investor’s risk aversion

w
Final portfolio:
n Risk free: 25.61%
n In Debt: 74.39%*40%=29.76%
n In equity: 74.39%*60% = 44.63%

Slide 14 Comm 324 --- W. Suo

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

Slide 15 Comm 324 --- W. Suo

 Extending to Include A Riskless Asset

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

Slide 16 Comm 324 --- W. Suo

 Alternative CALs

E(r) CAL (P) CAL (A)

M
M
P
P

A CAL (Global
A
minimum variance)
G


P M
Slide 17 Comm 324 --- W. Suo
 Portfolio Selection & Risk Aversion:
without borrowing/lending

E(r) U’’’ U’’ U’

Efficient
frontier of
S risky assets
P
Less
Q risk-averse
investor
More
risk-averse
investor
s
Slide 18 Comm 324 --- W. Suo
 Portfolio Selection & Risk Aversion:
with borrowing/lending

E(r) CAL
B

Q
P

A
rf F

Slide 19
s
Comm 324 --- W. Suo
 Example: Asset Allocation

w
Country Index Statistics

w
Optimal allocation:

US UK FRA GER Aus JAP CAD

0.69 0.05 0.00 0.00 0.13 0.13 0.00

Slide 20 Comm 324 --- W. Suo

 Portfolio Selection & Risk Aversion:
with borrowing/lending

w
With different borrowing/lending rate?

Slide 21 Comm 324 --- W. Suo