Chapter 19

Asset Allocation

Chapter Objectives
Explain how diversification among assets can reduce risk

Describe strategies that can be used to diversify among stocks

Explain asset allocation strategies Identify factors that affect your asset allocation decisions
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How Diversification Reduces Risk

Benefits of portfolio diversification

Asset allocation: the process of allocating money across financial assets with the objective of achieving a desired return while maintaining risk of a tolerable level

Building a portfolio
Portfolio: a set of multiple investments in different assets

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How Diversification Reduces Risk (contd)

Focus on Ethics: The risk of insider trading

Insider information: information known by insiders (such as managers) of a firm, but not known by investors Investors can legally only use information that is publicly available

Securities and Exchange Commission prosecutes violators

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How Diversification Reduces Risk (contd) Determining portfolio benefits

Compare return on the investments within the portfolio to the overall portfolio Diversification reduces the exposure of your investments to the adverse effects of any individual investment

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How Diversification Reduces Risk (contd) Factors that influence diversification benefits

Volatility of each individual stock

Impact of correlations among stocks
Highly correlated stocks limit diversification Consider stocks that are not influenced by the same conditions

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How Diversification Reduces Risk (contd)

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How Diversification Reduces Risk (contd)

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Financial Planning Online: Correlations among Stock Returns Go to: http://finance.yahoo.com/?u This Web site provides a graph that shows the returns on two stocks so that you can determine their degree of correlation. To perform your own comparison, insert a stock symbol, and then click on Charts

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Financial Planning Online: Correlations among Stock Returns (contd) Next, enter the symbol for another stock in the box just below the chart where is says Compare

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Strategies for Diversifying Among Stocks Diversification of stocks across industries

Less risky than a portfolio of stocks all from the same industry
Even such a portfolio is still susceptible to general economic conditions

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Strategies for Diversifying Among Stocks (contd)

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Strategies for Diversifying Among Stocks (contd) Diversification of stocks across countries

Economic conditions tend to vary among countries Foreign stocks typically more volatile than U.S. stocks so it is best to diversify among stocks within each foreign country Many advisors recommend an 80/20 split between U.S. and foreign stocks
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Asset Allocation Strategies

Including bonds in the portfolio

Bond and stock returns are not highly correlated Investing in more bonds lowers market risk but increases interest rate risk

Including real estate investments in the portfolio

Real estate investment trusts (REITs): trusts that pool investments from individuals and use the proceeds to invest in real estate

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Asset Allocation Strategies (contd)

Similar to closed-end mutual funds Managed by real estate professional

Types of REITs
Equity REITs: REITs that invest money directly in properties

Mortgage REITs: REITs that invest in mortgage loans that help to finance the development of properties

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Asset Allocation Strategies (contd)

Role of REITs in asset allocation

REITs could perform well when stocks or bonds are performing poorly

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Asset Allocation Strategies (contd)

Including stock options in the portfolio

Stock option: an option to purchase or sell stocks under specified conditions Traded on exchanges Call option: provides the right to purchase 100 shares of a specified stock at a specified price by a specified expiration date
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Asset Allocation Strategies (contd)

Exercise (strike) price: the price at which a stock option is exercised Premium: the price that you pay when purchasing a stock option Put option: provides the right to sell 100 shares of a specified stock at a specified price by a specified date

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Asset Allocation Strategies (contd)

The role of stock options in asset allocation

Very risky; should only pay a minimal role in asset allocation Covered call strategy: selling call options on stock that you own To maintain a low risk, asset allocation should emphasize low risk investments
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How asset allocation affects risk

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Asset Allocation Strategies (contd)

Benefits of asset allocation

Investors who diversify experience better performance

An affordable way to conduct asset allocation

Invest in different types of mutual funds

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Asset Allocation Strategies (contd)

Asset Allocation Strategies (contd)

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Factors That Affect the Asset Allocation Decision Your stage in life

Younger investors need safer, more liquid securities Investors not needing liquidity might consider investing in securities with high growth potential Investors nearing retirement may choose investments that will generate income
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Factors That Affect the Asset Allocation Decision (contd)

Your degree of risk tolerance Your expectations about economic conditions

If you expect a strong stock market, invest in stocks

If you expect a weak stock market, invest in bonds

If you expect lower interest rates, invest in long-term bonds

If you expect favorable real estate conditions, invest in REITs
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Copyright 2007 Pearson Addison-Wesley. All rights reserved.

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Financial Planning Online: Advice on Your Asset Allocation Go to: http://moneycentral.msn.com/

investor/calcs/assetall/main.asp

This Web site provides a personal recommended asset allocation considering your income, your stage in life, and other characteristics once you input some basic information

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How Asset Allocation Fits within Your Financial Plan Key decision concerning asset allocation for your financial plan are:

Is your present asset allocation of investments appropriate?

How will you apply asset allocation in the future?

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Integrating Key Concepts

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