Asset Allocation and Investment Policy

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					Asset Allocation and
Investment Policy

An investment strategy is based on four
 decisions
  1.   What asset classes to consider for investment
  2.   What normal or policy weights to assign to each eligible class
  3.   The allowable allocation ranges based on policy weights
  4.   What specific securities to purchase for the portfolio


85% to 95% of the overall investment return is
 due to the first two decisions, not the selection
 of individual investments
Asset Allocation
Strategies

 Integrated asset allocation
   capital market conditions
   investor’s objectives and constraints
 Strategic asset allocation
   constant-mix
 Tactical asset allocation
   mean reversion
   inherently contrarian
 Insured asset allocation
   constant proportion portfolio insurance
Integrated asset allocation

                                            Investor Assets,
      Capital Market                        Liab., Net Worth
      Conditions (C1)                       (I1)


      Prediction                            Investor Risk
      Procedure (C2)                        Tolerance
                                            Function (I2)


      E(R), Risk,                           Investor’s Risk
      Correlations (C3)                     Tolerance (I3)



                        Optimizer (M1)


                        Investor’s Asset Mix (M2)

                        Realized Returns (M3)
Strategic asset allocation


Used to develop a long-term policy allocation
Example: Portfolio will always rebalance to
 revert to a 60% Stock/30% Bond/10% Cash
 allocation
Practical issues:
  Frequency of rebalancing
  Reevaluation of the policy allocation
     ex. Northeastern’s endowment
Tactical asset allocation


 Used to develop short-term strategies to exploit changes
  in market conditions
 Often 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 rebalancing
   Constraints on “swing component”
Insured asset allocation


 Used to develop short-term strategies to exploit changes
  in investor’s objectives and constraints
 This is a portfolio insurance strategy
   Assumes investors become more risk-tolerant as wealth rises
      if stocks have performed above average relative to bonds,
       overweight stocks for next period
   Assumes investors become less risk-tolerant as wealth falls
      If stocks have performed poorly, underweight in next period
 Practical issues:
   Frequency of rebalancing
   Liquidity
Which Allocation Strategy is Best?




Define $ invested in stocks (S)
  S = m(A - F)
     where A = total asset value
           F = floor value for assets
           m = multiplier
           B = $ invested in riskless bonds (=A-S)
Three Strategies (A=100):
  Buy and Hold             (m=1, F=40)
  Constant Mix             (m=.6, F=0)
  Portfolio Insurance      (m=2, F=70)