CFP 3 Unit 8 Portfolio Management Theory, Portfolio Development, and Asset Allocation

EXAMPLE: CAPM expected return

Assume that the return on the market is currently 10%, the 90-day Treasury bill rate of return is 4.5%, and the beta coefficient of Stock X is 1.2. Therefore, the expected return on Stock X using the CAPM is 11.1%, calculated as follows: ri = 0.045 + [(0.10 − 0.045) × 1.2] = 0.045 + (0.055 × 1.2) = 0.045 + 0.066 = 0.111, or 11.1% Of this amount, the stock risk premium is 6.6%, and the market risk premium is 5.5%. This is the amount of additional return that the investor will need to invest (in excess of the risk-free rate of return) in the specific stock and overall market, respectively.

Sample Asset Allocations

Conservative risk-tolerant investor: (30/70) - 40% bonds - 30% money markets - 20% large-cap equity - 5% international equity - 5% small-cap equity This allocation is appropriate for an investor seeking higher yields and lower capital appreciation. Moderate risk-tolerant investor: (55/45) - 40% bonds - 5% money markets - 35% large-cap equity - 15% international equity - 5% small-cap equity This allocation is appropriate for an investor seeking a balance between yield and capital appreciation. High risk-tolerant investor: (80/20) - 20% bonds - 50% large-cap equity - 20% international equity - 10% small-cap equity This allocation is appropriate for an investor seeking higher capital appreciation and lower yields.

indifference curves

Each risk-averse investor (a fundamental assumption of MPT) will choose to establish a portfolio lying somewhere on this efficient frontier by implementing her own set of indifference curves. Indifference curves, which represent the risk-reward tradeoff that the investor is willing to make, will cross the efficient frontier in two locations, lie tangent to the efficient frontier, or not intersect the efficient frontier at all. The portfolio that lies at the point of tangency is the optimal portfolio for the investor. Different investors may have different indifference curves. For example, if the investor is very risk averse (i.e., conservative), the curve will tend to be very steep, indicating that a relatively large amount of additional return is necessary to entice the investor to assume the additional risk of a potential investment. Alternatively, if the investor is more risk tolerant (i.e., moderate or aggressive), the curve will tend to be less steep or flat, indicating that a smaller amount of additional return is necessary to entice the investor to assume additional risk. The efficient frontier provides the set of best possible choices for an investor. The actual portfolio the investor selects depends upon its utility function. A utility function reflects a given investor's tradeoff between risk and return. The indifference curve is a graphical expression of the utility function in the dimensions of expected return and risk. For a given level of return, at a certain point, an investor is indifferent to the amount of risk he is taking to achieve that return. Another way to look at it is that the investor is willing to take on an amount of risk (as measured by standard deviation) to achieve a certain return.

efficient market hypothesis (EMH)

In its purest form, the efficient market hypothesis (EMH) suggests that investors are unable to outperform the market on a consistent basis. The fundamental assumption of the theory, which was developed by Professor Eugene Fama of the University of Chicago, is that current stock prices reflect all available information for a company and that prices rapidly (or immediately) adjust to reflect any new information. In addition, any new information must be unexpected; therefore, any changes in the stock price resulting from this new information will be random (i.e., the random walk theory). If prices move in random fashion, any investment strategies or market techniques used to take advantage of market inefficiencies are theoretically useless. This hypothesis is the basis for the buy-and-hold strategy. In a truly efficient market, one can make the assumptions that ---there are a large number of competing participants; ---information is readily available; ---transaction costs are small (or zero); ---a security cannot be overvalued or undervalued; ---an investor cannot outperform or underperform the market; however, an investor can earn a return that is commensurate with the amount of risk assumed (no more, no less). Various investors and experts have different views on the EMH and its role in investing. If one were a true believer in the EMH, then one would buy only index funds, because the assumption is that it is impossible to beat the market if you believe that stocks cannot be undervalued. Many experts do not believe that the entire stock market is efficient, but rather that different parts of the market have varying degrees of efficiency. For example, many believe that the large-cap stocks tend to be more efficient than small-cap stocks, so one might buy an index fund for the large-cap allocation of the portfolio, but buy an actively managed fund for the small-cap allocation. Or, one might invest in an index fund representing large-cap stocks from developed countries but invest in an actively managed fund that invests in the emerging markets. Emerging markets are less efficient than developed markets, so they may offer more opportunities for an active manager than international-developed markets would.

efficient frontier

Markowitz used risk (as measured by standard deviation) and expected return as the basis for determining appropriate combinations of assets, or portfolios. The universe of these portfolios is, in turn, plotted on a risk-return parabola known as the efficient frontier. Specifically, this curve represents that set of portfolios that has the maximum rate of return for every given level of risk.

modern portfolio theory (MPT)

One important conclusion of his model is that unless the returns of the risky assets are perfectly positively correlated, then risk is reduced by diversifying across assets. The key point is that many investments are required to effectively diversify a portfolio, and that number depends primarily on the correlation between the investments. In 1952, Markowitz first developed the foundations of modern portfolio theory (MPT) by stipulating the following assumptions: ---Investors consider each investment opportunity as being represented by a probability distribution of expected returns over a specified holding period. ---Investors estimate the risk of the portfolio on the basis of the variability (i.e., standard deviation) of returns. ---Investors base decisions solely on expected return and risk; therefore, their indifference curves are a function of expected return and the expected variance of returns only. (Note: This assumption is often captured by the concept of mean-variance optimization.) ---Investors base their indifference to alternative investments on the maximization of wealth over a specified period, and this indifference diminishes as they get beyond this period. ---For a given level of risk, investors prefer higher returns to lower returns. The goal is to put together optimal portfolios—an approach referred to as mean-variance optimization. Mean-variance optimization requires that we look at the return (the mean) and the standard deviation (the variance) of each asset, as well as the correlation of each asset with every other asset.

anomalies

Stock market anomalies reflect behavior that contradicts the EMH; in other words, anomalies show that it may be possible to "beat the market." These anomalies have been identified and studied, but they can change and evolve over time—so investors have to be careful about treating these as trading rules. The more prevalent anomalies are outlined in the following: ---January effect. The January effect anomaly strives to take advantage of lower prices in December (in part due to tax selling), and then sell at higher prices at the beginning of the year. Studies done in other countries that do not have our tax laws also found abnormal returns in January, so the tax-selling explanation may not be the reason (or the entire reason). Like many of the anomalies, they often raise as many questions as they answer. One thing to note about the January effect is that more and more investors have become familiar with it and have tried to benefit from it. As a result of this, the January effect has begun to occur sooner, now in December (or even earlier). ---Dividend-yield anomaly. This anomaly found that over time, stocks paying higher dividend rates tend to outperform stocks paying lower dividend rates. ---Weekend effect. Research has found that stocks tend to peak in value on Friday, and then they generally decline in value on Monday. So, the time to buy is on late Monday, and sell on late Friday. The problem with this anomaly is that over time, the price movements may not be enough to cover transaction costs. ---Low P/E effect. According to this anomaly, investing in stocks with low price-to-earnings ratios is the best way to make money in the market. Studies have shown that generally low P/E stocks outperform high P/E stocks over time. ---Size effect. This is also referred to as the small firm effect. Studies have shown that over time, small firms do outperform large firms. Bear in mind, though, that the variability of returns (standard deviation) of small firms can be nearly twice that of large firms. ---BV/MV effect. The book-value-to-market-value effect comes from studies that show that stocks with high book values, relative to their market value, tend to outperform stocks that have lower book value, relative to their market value. This means that the higher the book value relative to market value, the more likely the stock may be undervalued. ---Neglected firm effect. The neglected firm effect is from studies that have shown that stocks followed by few or no analysts tend to outperform stocks followed by many analysts. Some believe that the neglected firm effect is just an extension of the small firm effect, since many "neglected" firms also tend to be small. ---Value Line enigma. Value Line researches stocks and then gives a rating for timeliness, with "1" being the highest rating, and "5" the lowest. Research has shown that investing in the stocks ranked "1" over time has provided superior results, but frequent trading will increase transaction costs and reduce returns

EXAMPLE: Arbitrage pricing theory

Terry has determined that the following unanticipated factors (and resulting risk premium) most affect the amount of expected return on his stock. In addition, he has estimated the following sensitivity coefficients for each of these factors Sensitivity Coefficient: - Inflation 110% (1.1) - Unemployment 80% (0.8) - Industrial production 50% (0.5) Risk Premium: - Inflation 5% - Unemployment 7% - Industrial production 6% The current risk-free rate is 2%. Therefore, using APT, the expected return on Terry's stock is 16.10%, computed as follows: ri = 0.02 + (1.1 × 0.05) + (0.8 × 0.07) + (0.5 × 0.06) = 0.02 + 0.055 + 0.056 + 0.03 = 0.1610, or 16.10%

security market line (SML)

The CML is a representation of the relationship of risk and return for all efficient portfolios. However, this reflects the macro level of the economy and does not focus on individual securities or portfolios that are more appropriate for the average investor. As a result, Sharpe needed to develop something at the micro level to quantify the risk/return relationship for individual securities. This is the purpose of the security market line (SML), which depicts the relationship of risk and return for individual efficient portfolios and has the same formula as that for the CAPM. The graph of the CAPM is called the SML, with intercept equal to the risk-free rate and slope equal to the market risk premium. You should observe that, unlike the CML, the SML uses beta as its risk measurement on the horizontal axis. If security markets are in equilibrium (an assumption of Sharpe's capital market theory), all individual assets should plot along the SML. In other words, the expected return for any asset should be equal to its required return. If the expected return for an asset was greater than the required return, the asset would be considered undervalued and would plot above the SML. Likewise, if the expected return was less than the required return, the asset would be considered overvalued and would plot below the SML. Investors would have no interest in buying or holding this investment. The resulting excess supply of the asset would force the asset's price down (and thus, increase the expected return). Expected return > required return = undervalued Required return > expected return = overvalued Investors would purchase undervalued assets and sell (or short) overvalued ones. On one hand, this action would create excess demand for undervalued assets and drive their prices higher. On the other hand, it would result in an excess supply of overvalued assets, forcing prices down. The process of buying and selling would continue until the profit opportunities are exhausted. This point is reached when the prices of undervalued assets rise to their equilibrium prices and the prices of overvalued assets fall to their equilibrium prices. When that happens, every asset enters an equilibrium state and plots along the SML. Factors affecting SML: if inflation increases, this would cause a parallel shift up in SML. Another example, other things constant, the slope of the SML becomes steeper when investors in general become more risk averse than before; and flatter if investors become less concerned with risk than before. The SML generally relies on historical data; however, past betas may not accurately reflect what is going to happen in the future. For this reason, analysts who use betas will often make subjective adjustments to the historical data to reflect what their expectations are for the future.

core and satellite

The core and satellite investment strategy invests in both broad market indices (core) and higher-risk alternatives (satellite). Core investments may include U.S. stocks, U.S. fixed-income, and developed international equities. Generally, these investments track a major market index such as the S&P 500, Russell 3000, and MSCI EAFE. This part of the portfolio uses a passive investment philosophy to achieve market-based returns. Satellite investments may include REITs, emerging markets, and high-yield bonds. These investments attempt to achieve above-market returns through high risk and global exposure. Investors may choose to implement a core and satellite strategy through a portfolio of mutual funds. The goals of this strategy are to reduce portfolio risk through diversification, generate higher returns commensurate with required returns, minimize transaction costs, and manage taxes. You can think of the core and satellite invest strategy as really a combination of strategic asset allocation and TAA: the core of the portfolio uses the strategic approach and the satellite portion uses a tactical approach.

capital asset pricing model (CAPM)

The end result of capital market theory (and the practical application of Sharpe's work) was the derivation of the capital asset pricing model (CAPM), which is written as follows: ri = rf + (rm - rf)βi where: rm = market return rf = risk-free return βi = beta coefficient of the stock The CAPM allows the investor to determine an asset's expected rate of return, a form of risk-adjusted return encapsulating how much risk the investor should assume to obtain a particular return from an investment. The model is made up of two separate components. One component is known as the stock risk premium [(rm− rf)βi] and the other component is the market risk premium [rm − rf]. The stock risk premium is the inducement necessary to entice the individual to invest in a particular stock, whereas the market risk premium is the incentive required for the individual to invest in the securities market in general. The CAPM accounts for the impact of systematic risk (as measured by beta) only and does not take into consideration unsystematic risk, which is assumed to have been diversified away. The major contribution of the CAPM to investment theory was the creation of a quantitative investment risk measure and a statistical association with the investment's expected rate of return. The CAPM links together risk and return and helps investors make prudent investment decisions. Specifically, the CAPM allows us to calculate the expected rate of return for an investment and compare it to an investor's required rate of return for that investment. For example, if the CAPM expected rate of return is higher than the investor's required rate of return, and all other investment considerations being equal, a positive investment decision is warranted. Conversely, if the CAPM expected rate of return is lower than the investor's required rate of return, the investment should be rejected. Like Markowitz, Sharpe also stipulated that certain assumptions must be present for the CAPM to be used. The most important of these assumptions are as follows: ---All investors have the same expectations—that is, they estimate identical probability distributions for a given investment. ---Investors can always borrow or lend money at the risk-free rate of return as represented by the yield on U.S. short-term securities, such as the 13-week (90-day) Treasury bill. ---No taxes or transaction costs are involved in buying or selling investment assets, meaning that these expenses are not relevant in investment decision-making. ---At all times, capital markets are in equilibrium, meaning that all investments are properly priced, taking into account the commensurate level of investor risk. Thus, the CAPM establishes a theoretical baseline by which to evaluate the suitability of any investment for any investor.

strategic asset allocation

The purpose of strategic asset allocation is to determine an appropriate allocation based on the long-term financial goals of the client. Accordingly, the risk tolerance of the client is assessed in conjunction with the current phase in the client's life cycle. For example, a client who is in the asset accumulation phase (i.e., younger, with or without children) will likely be able to tolerate more risk than a client who is in the gifting years (i.e., retired and focusing primarily on estate planning and asset distribution to heirs). An investor's life cycle consists of three phases: (1) asset accumulation, (2) conservation or protection, and (3) distribution or gifting. Each phase typically coincides with the investor's age, professional career, and retirement.

EMH Forms

The weak form holds that current stock prices have already incorporated all historical market data and that historical price trends are, therefore, of no value in predicting future price changes. Although fundamental analysis and insider information may produce above-market returns under the weak form, technical analysis is of no value. Indeed, none of the forms of EMH attribute any value to technical analysis. The semistrong form holds that current stock prices not only reflect all historical price data but also reflect data from analyzing financial statements, industry, or current economic outlook. Thus, even fundamental analysis is of no value in this form, and only insider information may produce above-market returns. Technical analysis is also of no value. The strong form holds that current stock prices reflect all public and private information. Therefore, even insider traders are unlikely to consistently outperform the market. In addition, neither technical analysis nor fundamental analysis is of any value. (You should note that this form has effectively been negated in recent years, given the considerable illegal profits made by investors who possess insider trading information.) In other words, the relevant information for each form: - weak: insider info, credible fundamental analysis - semi-strong: insider information - strong: nothing lol The EMH is a theory when it comes to market analysis, and does not mean that technical analysis should be considered useless. As with any analysis, technical and fundamental analysis can be useful, so long as they are not used in isolation. These should just be a few of many moving parts used to analyze investments.

Monte Carlo simulation (MCS)

This simulation is an analytic and risk management tool widely used in finance. The MCS incorporates computer programming to generate stochastic (probability) random value inputs in simulating thousands of iterations. In a MCS, each of the variables is also given a probability distribution to allow for real-world uncertainty. Consider the uncertainty in retirement planning. Small changes in the projected rate of return will make a dramatic difference in the outcome. Life expectancy is also another important variable that may be incorrectly approximated. MCS uses a random number generator to provide an output with specific probabilities of outcomes. The following are advantages: ---The MCS can clearly display tradeoffs of risk and return. The paths can be ranked from best to worst to assess the probability of any given outcome. ---Properly modeled tax analysis, which considers the actual tax rates of the investor as well as tax location of the assets (held in taxable or tax-deferred locations), can be assessed. ---Tax burden changes with market returns and withdrawals could be considered. ---A clearer understanding of short-term and long-term risk can be gained. For example, reducing the holdings of risky stock would reduce the short-term variability of the portfolio but increase the long-term risk of not having sufficient assets. ---The MCS can better model the real stochastic process where return over time depends not only on the starting value of the period but also on the additions or withdrawals to the portfolio at each future period. ---Points along the time line can be considered to answer questions such as: "Do savings need to be increased?" and "Can I retire earlier?" and "Must I retire later?" The following are disadvantages: ---There is a simplistic use of historical data, such as expected returns, for the inputs. Returns change and have a major effect on projected future values of the portfolio. ---There are models that simulate the return of asset classes but not the actual assets held. Simulating the return of the Wilshire 5000, when the actual portfolio fund has fees, could significantly overstate the future value or time period over which distributions can be sustained.

Value and Growth Investing

Value and growth investing are really just different sides of the same "investment coin." In this case, the investment coin is the price-to-earnings (P/E) ratio. Value investing is a strategy that tends to concentrate on the numerator (or price), while growth investing focuses on the denominator (or earnings). Specifically, value investing assumes the current P/E ratio is below its natural level, and that an efficient market will soon recognize this situation and drive the stock price upward. In contrast, growth investors assume the P/E ratio will remain constant over the near term, and the stock price in an efficient market will increase as the forecasted earnings growth of the issuing company is realized. Such investors look for growth stocks—that is, stocks of companies that have a significant ability to develop products with a minimum of marketplace competition. These stocks usually have a superior rate of earnings growth (e.g., 15% per year or more), low dividend payouts, and an above-average price-to-earnings ratio. However, growth stocks are generally more volatile and, as a result, exhibit higher betas than other stocks. The value approach could be considered slow and steady, while the growth approach is more aggressive.

capital market theory

William Sharpe continued the work of Harry Markowitz and added to MPT with a branch of research known as capital market theory. Sharpe said it was possible to identify a portfolio on the Markowitz efficient frontier that would be considered the market portfolio (M). In turn, this market portfolio consists of all risky assets (i.e., those with both unsystematic and systematic risk). A line could then be drawn from the risk-free rate of return (rf) on the vertical axis, or Y-axis, through Portfolio M. This line becomes the new efficient frontier and is known as the capital market line (CML).

investment policy statement (IPS)

a key component of a client's investment strategy, is a written document that sets forth a client's objectives, placing boundaries on the portfolio's asset allocation and investment guidelines as well as limitations on the investment manager. This statement gives guidance to the investment manager and provides a means for evaluating investment performance. An allocation among asset classes (and their respective weights) that is congruent with the client's primary investment objective is a part of any credible investment policy. In addition, review guidelines and rebalancing frequency are commonly included. Such a policy is not really optional because an investor has either implicitly (by default) or explicitly (in writing and as part of an IPS) adopted some form of investment policy and asset allocation strategy. A well-drafted IPS reduces ambiguity and provides guidance to any and all investment professionals needing to interact to implement the IPS. In addition, when investment recommendations are made, the recommendations can be evaluated against the standards set in the IPS to determine suitability. IPS serves 4 basic purposes: 1. Setting objectives. 2. Defining the asset allocation strategy 3. Establishing management procedures 4. Determining Communication procedures IPS Standards: --Return requirement: An easy way to create a return requirement would be to take the expected absolute return for the portfolio and add it to the average rate of inflation. This requirement can also be expressed in the IPS as "returns will outpace the rate of inflation by an average of 5%. --Risk tolerance: should state if the portfolio volatility is to be low, below average, average, above average, or high. There are two major areas to address with risk tolerance: (1) the ability to take risk, and (2) the willingness to take risk. --Liquidity: many advisors don't invest funds needed within the next 5 years. --Time Horizon: short, intermediate, long --Laws and regulations --Taxes: All investment alternatives should be analyzed on an after-tax basis so that the returns from tax-exempt investments are comparable to taxable investments. Alternatives to tax-exempt securities (i.e., municipal bonds) include tax-deferred investments, such as qualified plans, IRAs, insurance-based investments, and growth stocks (non-dividend-paying common stock). --Unique preferences and circumstances --Permitted and excluded investments

stochastic modeling

a method of financial analysis that attempts to forecast how investment returns on different asset classes vary over time by using thousands of simulations to produce probability distributions for various outcomes. A popular form of stochastic modeling that uses computer-generated distributions is the Monte Carlo simulation (MCS).

tactical asset allocation (TAA)

continuously adjusts the asset allocation and class mix in an attempt to take advantage of changing market conditions and overall investor sentiment. In TAA, portfolio adjustments are driven solely by perceived changes in the market values of the asset classes, and very little consideration, if any, is given to the long-term financial goals of the client. In essence, TAA is a market timing approach to portfolio management that is intended to take advantage of perceived market inefficiencies (and opportunities for investor profit). Inherently, TAA is characterized by a fundamentally contrarian approach to investing. As such, the portfolio manager is constantly buying an asset class that is currently out of favor with most investors. In addition, transaction and turnover costs in reallocating these asset classes are much higher if the manager uses TAA instead of the more common strategic asset allocation approach.

arbitrage pricing theory (APT)

ri = a0 + b1F1 + b2F2 + . . . + bnFn + e The CAPM explains the returns on stock as a result of only one factor: the volatility of a stock relative to the market as a whole (as measured by beta). What if there are other unanticipated factors that explain the expected return of a stock? Those other unanticipated factors are what the arbitrage pricing theory (APT) attempts to quantify. Proponents of APT assert that the expected returns on securities are based on various unexpected or unanticipated factors. In turn, these factors affect the amount of risk premium that an investor will demand to entice him to make a potential investment. Many potential factors affect the expected return of a security; some of these factors affect all securities, whereas others affect only a specific industry or sector of the economy. The general factors can be classified into two major categories: sector influences and systematic influences. Sector influences are those that affect a company's industry. For example, factors that affect a bank are different from those that affect an airline. And factors that affect an automobile manufacturer differ from those that affect a computer software manufacturer. Systematic influences are those that affect businesses generally. For example, all businesses are affected by changes in interest rates and by changes in overall economic activity. Four primary factors have been found under APT to affect a stock's return. These factors are as follows: 1. Inflation 2. Industrial production (or changes in GDP) 3. Risk premiums 4. Yield curves (interest rates) In the CAPM, a single factor—a security's beta with respect to the market portfolio—is used to value assets. The APT, on the other hand, is a multifactor model that is an alternative to the CAPM. Under the APT, the market portfolio no longer plays a pivotal role in pricing assets. In theory, the use of APT should allow an investor to obtain superior performance. In practice, APT alone may be less successful than bottom-up stock picking using fundamental analysis. To continually and correctly anticipate unexpected changes in macroeconomic factors such as inflation, interest rates, GDP, and other variables is a rather daunting task. Most successful investment managers do not try to incorporate economic projections into their analyses. They stick to a bottom-up approach of stock picking and ignore economic conditions. Unexpected factors regarding a company and its industry must also be anticipated to achieve superior performance using APT. One of the most significant factors affecting stock prices is earnings surprises. Analysts continually revise their earnings forecasts for companies. In spite of all the analytical work that goes into earnings forecasts, approximately 40%-60% of actual earnings reports differ from consensus forecasts, even taking into account the constant earnings revisions that analysts make in an attempt to hit the moving target.

random walk

states that future stock prices are random and do not follow any preestablished trend or path. This hypothesis does not mean that the security prices themselves are randomly determined; rather, it indicates that all the information up to this point in time has been priced into the security, and any future price movement will be based on any future information. If one believes markets are efficient, then everything has been priced into any given security up to this point—and the future price is random based on whatever happens in the future, good or bad.

capital market line (CML)

the line on a graph of return and risk (standard deviation) from the risk-free rate through the market portfolio. A line could then be drawn from the risk-free rate of return (rf) on the vertical axis, or Y-axis, through Portfolio M. This line becomes the new efficient frontier and is known as the capital market line (CML). rp = rf + σp [(rm − rf) / σm] where: rp = expected return of the portfolio rf = risk-free rate of return rm = market rate of return σp = standard deviation of the portfolio σm = standard deviation of the market As the investor proceeds along the CML (toward Point A), he is becoming more aggressive in making investments, including making use of margin and leveraging his investment assets (borrowing portfolio). As the investor proceeds back along the CML toward the risk-free rate of return (rf), he is becoming conservative in making investments and is investing more in risk-free government securities (lending portfolio). The development of the theoretical CML allows people to see that the risk and the potential return of various asset classes do increase along a relatively straight line. The significance of the CML is that it leads to the derivation of the security market line, which investors can and do use in practice. The most important feature of the CML is that all assets located on the line are perfectly positively correlated (+1.0 correlation coefficient) with the market portfolio, which is a fully diversified portfolio. In other words, like the market portfolio, all other portfolios located on the CML are fully diversified. Real life is not this way so to be more practical and value real-life portfolios and assets you can use security market line.

asset allocation

the process of apportioning an investor's wealth among different countries and asset classes for investment purposes. Asset allocation is the main determinant of a portfolio's total return. Historically, these investment classes have consisted of cash and cash equivalents, equities (stock), and debt (bonds). However, recently (and more properly), the potential investment classes have been broadened to also include real estate, international investments, collectibles, and precious metals. Most financial planners who provide investment counseling use some type of mean-variance optimization software to determine an optimum portfolio or asset allocation based on a client's goals, risk tolerance, time horizon, tax situation, and economic forecasts. This tool is used to spread investments across different assets within a portfolio by assessing the tradeoff between risk and return. The goal in using these software packages is to build an efficient portfolio for the client that maximizes the return and minimizes risk. The process of asset allocation is very important because academic studies have shown that approximately 90% of the variability of the long-term investment performance of assets is attributable to their allocation and weight within an investor's portfolio. Considerations: ---An assumption of the client's level of investment risk and time horizon ---The client's past experience level with investments ---The client's expressed or determined required rate of return ---The tax status of the client When constructing an asset allocation policy, four decisions should be made: 1. What asset classes should be considered for investment purposes? 2. What weights or percentages should be assigned to each of these asset classes? 3. What is the allowable allocation range based upon these weights? 4. What specific securities should be purchased for the portfolio?

sensitivity analysis

used to evaluate the risk associated with a given investment and assesses the impact of different variables on an investment's returns. When evaluating a particular investment, investors may use forecasted cash flows to estimate its intrinsic value. However, many variables (e.g., business cycle) may either negatively or positively impact the forecasted cash flows and resulting valuation with varying degrees of sensitivity. Generally, investors, while performing sensitivity analysis, will calculate both the net present value (NPV) and the internal rate of return (IRR) of the forecasted cash flows. This calculation will be performed on the basis of three different assumptions: pessimistic, expected, and optimistic. By changing one of the input variables, subsequent changes in NPV or IRR can be reviewed and analyzed. Investors may choose an investment based on the reliability of the outcome for a given variable.