What is it?

1. What is it? • Asset allocation involves selecting the proportions of various types of assets to include in a portfolio. • In designing an overall asset allocation strategy, the advisor must consider which asset classes to include for a particular client. • Proper asset allocation improves a portfolio’s risk-adjusted return. • The asset allocation decision is a prelude to selecting individual securities or funds for portfolio inclusion.

2. Asset Allocation • The relationship of return and risk is an important investment planning concept. • Generally, riskier investments must offer a higher potential return to compensate for the added risk. • Combining two or more risky assets can actually reduce the risk of the overall portfolio, as long as they are not highly correlated. • Highly correlated assets tend to move in the same direction and at a similar magnitude, while assets that are not highly correlated do not. • Investors can use non-highly correlated assets to build portfolios with more favorable risk/return relationships.

3. Example • Consider four potential investments that have the following expected returns for next year depending on three possible economic environments, each of which is equally likely to occur:

4. Example • Asset A is a risk free asset. • Now consider three potential portfolios where we purchase an equal amount of two risky assets (50% of each).

5. Example • All three portfolios offer the same 10% expected return as the individual assets. • The variability of Portfolio BC (the average variability of assets B and C) does not achieve any reduction in risk because Assets B and C are perfectly correlated (a correlation coefficient of 1.0). • They both do well in strong business conditions and poorly in weak conditions.

6. Example • The expected variability of Portfolio CD is less than the variability for each of the individual assets. • This portfolio would be preferred to individual assets B, C and D since it offers the same expected return but lower risk. • Assets C and D are perfectly negatively correlated. • One asset is always up when the other is down. • Portfolio BD offers the same expected return as assets B, C and D but no variability. • Assets B and D are negatively correlated. • This portfolio offers a higher return for the same expected risk as Asset A, making it the most preferable portfolio for a risk-averse investor.

7. Asset Allocation • By combining assets that are not highly correlated together in portfolios, the investor can achieve a more favorable risk/return relationship. • It is not necessary for assets to be negatively correlated to achieve this benefit. • Small positive correlations (assets that occasionally, but not always, move in the same direction) also reduce risk.

8. Modern Portfolio Theory and Asset Allocation • A fundamental principal of modern portfolio theory (MPT) is the ability to reduce risk for a given level of return. • Properly constructed portfolios of assets that are not highly correlated achieve the highest possible return for a given level of risk. • MPT measures risk as standard deviation of returns.

9. Modern Portfolio Theory and Asset Allocation • The standard deviation for a portfolio of assets can be determined as follows: N N N σP = [SQ.RT.(wi2σi2 +  wiwjσiσjCorrij)], i=1 i=1 j=1 • Where the standarddeviation of the portfolio, σP, is based on the weights, w, and standard deviations of each asset, σ, in the portfolio and the correlation between all pairs of assets, i and j. • For two assets, the equation becomes: σP = [SQ.RT.(w12σ12 + w22σ22 + 2w1w2σ1σ2Corr12)].

10. Example • Consider two assets with the following expected returns, standard deviations, and correlation: • The low correlation between A and B indicates that we should be able to benefit from combining these assets in a portfolio.

11. Example • Now consider the following potential portfolios, with varying weights of A and B in the portfolio:

12. Example • The expected return is always the weighted average return of the underlying assets. • The standard deviation of each portfolio is based upon the standard deviation formula for the two-asset portfolio above. • For a risk adverse investor, note that relative to portfolio 1, portfolio 2 offers a 6.7% higher return but has only a 5% increase in standard deviation. • The return/risk ratio is 1.20 for portfolio 1 and 1.212 for portfolio 2. • Portfolio 2 offers a greater return relative to risk compared to portfolio 1. • The relationship between risk and return for these portfolios can be graphed.

13. Example

14. Example • An investor could choose the combination of assets A and B which provides them with their desired return while maintaining an acceptable level of risk. • Portfolios of more than two assets make the math more complex, but the basic concepts are the same. • Adding assets with low or negative correlations to the rest of the portfolio improves the return/risk relationship.

15. Modern Portfolio Theory and Asset Allocation • Overall portfolio asset allocation decisions are made using the expected returns, standard deviation, and correlations between asset classes, rather than individual assets. • An asset class is a group of securities with similar characteristics. • Broadly speaking, the major asset classes include stocks, bonds, real estate, cash, commodities, and international investments. • Within each asset class, however, there can be various gradations that sometimes constitute their own asset class. • Asset allocation strategies must also consider the appropriateness of each asset class for the particular investor or account.

16. Modern Portfolio Theory and Asset Allocation • The advisor should attempt to generate an efficient frontier of potential portfolios. • This can be achieved using asset allocation software and the expected returns, standard deviations, and correlations of the asset classes. • The efficient frontier represents those portfolios with the highest expected return for a given level of expected risk

17. Modern Portfolio Theory and Asset Allocation • Portfolio A on the efficient frontier might represent a portfolio concentrated in short-term fixed income securities such as Treasury Bills. • Portfolio B might represent a portfolio concentrated in risky securities such as emerging market equities. • As with the simplified example for assets A and B above, the efficient frontier can be used to present to a client potential portfolios based on upon their desired returns or the level of risk they are willing to take.

18. Modern Portfolio Theory and Asset Allocation • Efficient frontiers can easily be generated based upon historic relationships between asset classes or expected relationships. • The challenge is determining which point on the efficient frontier should be selected for a particular client. • Theoretically, if we could measure the utility (satisfaction) that an investor obtains from different levels of returns relative to risk, we could draw a set of indifference curves for each investor. • Indifference curves represent the different combinations of risk and return to which an investor is indifferent.

19. Modern Portfolio Theory and Asset Allocation • Optimally we would select the investor’s highest indifference curve that touches the efficient frontier • The point of highest utility (satisfaction per level of returns relative to risk) for the investor.

20. Modern Portfolio Theory and Asset Allocation • Lacking a precise measure of an individual’s risk/return preferences, advisors typically use judgment to select an appropriate point on the efficient frontier based on some measure of the investor’s risk tolerance. • Example: Classifying investors: • Conservative • Intermediate • Aggressive • The investor is then placed in the relevant section of the efficient frontier

21. Modern Portfolio Theory and Asset Allocation • Additional degrees of risk tolerance can also be used. • Example: • Aggressive Growth • Growth • Growth and Income • Income • Safety • The categories including growth are typically concentrated in equities, with a large portion of the expected return derived from appreciation. • Income, by contrast, typically includes investments such as bonds where the current yield is an important component of return. • When constructing a portfolio based on a client’s investment policy statement, the advisor should include the constraints and preferences in determining an appropriate allocation.

22. Strategic Asset Allocation • A strategic asset allocation can be thought of as the long-range plan for a portfolio. • Taking into consideration the long-range return requirements and risk tolerance, allocations to various asset classes are developed. • Assets are periodically rebalanced to conform to the original allocation. • Typically, the strategic allocation is not altered due to short-term issues such as current market conditions (perceived current relative value of different asset classes).

23. Strategic Asset Allocation • Rebalancing is necessary since the asset classes will have different returns. • Higher returns in a particular class and/or dividends and interest that are reinvested in the same asset class or held in cash can affect the overall strategic position. • Overperforming securities will be sold and underperforming securities will be purchased until the original asset allocation is attained. • This enforces a discipline to sell the best performing asset classes and buy the lowest performing (buy low, sell high). • Alternatively, a momentum investing strategy would suggest no rebalancing – letting the winners run.

24. Example • Consider an investor who has created a strategic asset allocation of 30% bonds, 30% commodities and 40% stocks. • Guideline (set by investor): The portfolio will be rebalanced when any asset class varies from the strategic allocation by more than 500 basis points (5%). • Over the next five years, the assets exhibit the following return pattern:

25. Example • How frequently will the portfolio be rebalanced? How will strategic rebalancing affect the ending value of the portfolio relative to letting the winners run? • First, consider an initial portfolio of $1 million that is allowed to run: • The ending value of the portfolio is $1,184,873.

26. Example • Now consider the percentage of the portfolio in each asset for the period: • At the end of year 1, the allocations are 29% bonds, 32% commodities and 39% stocks. No allocation has drifted by more than 500 basis points from the strategic goal, so no rebalance is necessary. The same applies at the end of year 2.

27. Example • At the end of year 3, the allocation to bonds has fallen by 800 basis points relative to the strategic allocation, and the allocation to commodities has risen by 800 basis points. • According to the guidelines, the portfolio needs to be rebalanced. Doing so results in the following adjustments: • If this newly rebalanced portfolio is allowed to run, the ending value of $1,247,138 is $62,265 higher than the original ending value. • However, the guidelines may require another rebalancing in the future.

28. Example • Going forward, the percentage of assets changes as follows: • At the end of year 4 there is an imbalance of more than 500 basis points • There is too high an allocation to bonds. • The portfolio must be rebalanced a second time at the end of year 4, to the following allocations:

29. Example • After the new rebalancing is completed and the final year elapses, the ending value of the portfolio is still $40,919 better than would have been achieved from letting the assets run from year 1 on. • It is $21,346 lower than it would have been if the second rebalancing had not been done. • In year 5 bonds continued to do well, while stocks and commodities continued to fall.

30. Strategic Asset Allocation • There is no way of knowing in advance whether the trends will continue or reverse in a given year. • It is generally best to decide in advance how frequently to rebalance in order to retain the desired level of risk for the client’s portfolio.

31. Tactical Asset Allocation • Attempts to capitalize changing market conditions. • Contrasts strategic allocation • The overall asset allocation is frequently adjusted to take advantage of perceived opportunities in the current market. • Example: In a high interest rate environment, the advisor may shift the asset allocation to favor long-term bonds. • The rewards of tactical asset allocation depend on the advisor's ability to predict which asset classes will perform best in the near term. • Strategic asset allocation is generally a low turnover investment strategy, while tactical asset allocation generally results in high turnover.

32. Example • Consider the investor from the previous example, who starts with the same $1 million portfolio and strategic allocation guidelines. • The advisor is given discretion to shift the allocation tactically once per year as long as the starting allocations are within 500 basis points of each asset’s strategic goal. • The advisor decides to follow a momentum strategy that overweights the previous year’s top-performing asset by 500 basis points and underweights the worst-performing asset by 500 basis points.

33. Example • The resulting performance is as follows: • Years 1 and 2

34. Example • Years 3 and 4

35. Example • Year 5 • The manager’s tactical rebalancing results in a higher ending value than either the untouched portfolio or the one that was strategically rebalanced. However, the $6,446 improvement over strategic rebalancing may not have justified the higher trading costs from larger and more frequent allocation adjustments.

36. Controlling Volatility • Asset allocation is a means of controlling the volatility that is inherent in investment returns. • Some investors may have a high degree of risk tolerance and desire to achieve the maximum possible return regardless of risk. • Other investors may not sleep well at night with volatile portfolio values. • Some investors who think they can tolerate risk, may have circumstances where volatility can impair their ability to maintain a certain standard of living. • Example: During retirement, consistent withdrawal rates may not be possible given the volatility of returns. In spite of the anticipated returns and inflation rates, the maximum safe withdrawal rate may be lower than anticipated.

37. Controlling Volatility • Methods of reducing and moderating volatility • Creating a diversified portfolio with assets that are not highly correlated • Time • If an investor has a long time horizon before investment withdrawals are to begin the impact of volatility is dampened over time. • Hedging strategies and options strategies such as covered calls • Covered calls involving selling a call option on a currently held investment, which sells some of the upside and reduces the potential downside (from the collection of the option premium), reducing the standard deviation of the portfolio. • Downside risk can also be reduced through the purchase of put options.

38. Monte-Carlo Simulation • Expected returns and standard deviation are not necessarily constant over time. • The return in an individual period is also not necessarily predictable. • Returns in each asset class are probabilistic. • Investors may also make periodic deposits and withdrawals • Increases the difficulty of predicting long-term returns and risk.

39. Monte-Carlo Simulation • Monte-Carlo simulation assesses the likelihood of an expected outcome. • A computer program randomly chooses returns from an expected distribution of returns for each period (perhaps rebalancing the asset allocation if required under the strategy). • Each run results in an ending expected portfolio value. • The process is run many times (perhaps 1,000) to achieve a distribution of ending values. • This process can help assess the probability of achieving a certain value or income in the future. • Including the possibility that an individual will outlive his retirement assets

40. Example • Volatility has a significant impact on the ability of a client to make desired retirement withdrawals during retirement. • The impact of volatility on the sustainability of retirement distributions can be demonstrated using Monte-Carlo simulation. • Assume that an investment adviser has the following market expectations: • Expected long-term correlation of stocks and bonds 0.20

41. Example • Consider a retired client who has a $1,000,000 portfolio. • The client would like to withdraw as much as possible each year with that amount increasing for inflation. • Ideally the client would like to withdraw about $40,000 (4% of the initial portfolio amount) adjusted for inflation each year. • Using Monte-Carlo simulation software (MCRetire – www.effsols.com) you can compute the probability of success (the ability to withdraw $40,000 each year adjusted for inflation over the next 30 years without running out of money). • Using a 9% expected return for stocks, 20% expected standard deviation for stocks and 3% inflation • Running one million iterations the Monte-Carlo simulation reveals: • There is about an 80% probability of success with a 100% stock portfolio. • 20% of the 30 year time periods the client would run out of money within 30 years (not an attractive scenario for most clients).

42. Example • The software can also be run to output the maximum safe initial withdrawal given a certain desired probability of success. • If a client want to be 95% certain not to run out of the money, the Monte-Carlo simulation reveals that the maximum safe withdrawal amount is about 2.6% ($26,0000 rather than $40,000). • Running the Monte-Carlo simulation with a 100% bond portfolio reveals that there is an 66% probability of success at withdrawing $40,000. • Conversely, to achieve a 95% probability of success the maximum safe initial withdrawal rate is about 2.9%.

43. Example • By creating a portfolio of two asset classes (stocks and bonds) that are not highly correlated, the sustainability of withdrawals can be improved. • Take a portfolio of 50% stocks and 50% bonds. • From the above data, the expected return on the portfolio would be 7.75% with a standard deviation of 11.76%. • Running Monte-Carlo simulation reveals that the combined portfolio would have an 86.5% probability of succeeding with a 4% withdrawal rate. • To achieve a 95% probability of success the maximum safe withdrawal rate would be about 3.3%. • The diversified portfolio outperforms both the stock only and bond only portfolios, once again demonstrating the advantages of asset allocation in controlling volatility.

44. Example • Note that the diversified portfolio has a lower expected return than the stock only portfolio and the average expected wealth accumulation would be lower than a stock only portfolio. • Potential strategy: Using a higher equity allocation during the pre-retirement years and switching to a more diversified portfolio during retirement years for risk averse clients.

45. Individual Security Selection • Once the asset allocation decision has been made, the next step is to select individual securities (stocks, bonds, etc.) or mutual funds within each asset class. • As with the overall asset allocation strategy (strategic vs. tactical), this can be either passive or active. • In a passive approach, the advisor selects broad diversified portfolios representing each asset class. • Such as index mutual funds or exchange-traded index funds) • In an active approach, the advisor selects individual securities or traditional, actively managed mutual funds within each asset class that are expected to outperform their peers. • It requires more frequent monitoring, security selection, and buy/sell decision.

46. Individual Security Selection • The choice between the active and passive approaches depends upon an advisor’s beliefs about market efficiency and the advisor’s ability to select, in advance, better performing securities or funds. • Efficient markets generally assume rational behavior by market participants and a number of anomalies have been shown to occur. • A study of behavioral finance can help the advisor understand investor behavior both in selecting investment strategies and educating clients to avoid some common pitfalls.

47. Market Hypotheses • The Efficient Market Theory (EMT) hypothesizes that securities markets process information efficiently. • This implies that new information about a security is quickly (almost instantaneously) reflected in its price. • In order for the market to be efficient, certain conditions must be met: • A large number of profit maximizing investors competing in the market • A free, random flow of information • However, some factors can still limit an investor’s ability to trade (e.g., 1987 exchange rules).

48. Market Hypotheses • Strong Form EMT • Argues that all information, whether public or not, is reflected in security prices. • Assumes the existence of a perfect market. • Under this form, no participants would be able to consistently perform better than the market other than by random luck.

49. Market Hypotheses • Semi-Strong Form EMT • Argues that all public information is reflected in stock prices. • This includes prices of securities, security volume data, financial reports, press releases, statements of company officers, newspaper articles, and the work of sell-side securities analysts, as well as many other types of information.

50. Market Hypotheses • Weak Form EMT • Argues that security prices reflect only market data, such as historical trade prices, volume, and order size. • Under this form, an investor could use fundamental analysis tools such as financial statement analysis and other fundamental information to glean information that has not been efficiently priced. • This information could be used to outperform the market. • Technical analysis (charting of security price and volume data) would still fail to provide consistent out-performance, because it relies on market data.