Asset Allocation and Investment Policy

An investment strategy is based on four decisions

1. 2. 3. 4. What asset classes to consider for investment What normal or policy weights to assign to each eligible class The allowable allocation ranges based on policy weights 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 investors 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, Liab., Net Worth (I1) Investor Risk Tolerance Function (I2) Investors Risk Tolerance (I3)

Capital Market Conditions (C1)

Prediction Procedure (C2)

E(R), Risk, Correlations (C3)

Optimizer (M1) Investors 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. Northeasterns 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 investors 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 Constant Mix Portfolio Insurance (m=1, F=40) (m=.6, F=0) (m=2, F=70)