Course 3 Module 11. Asset Allocation and Portfolio Diversification

Strategic asset allocation (SAA) is the portion of the portfolio that has asset class mix for the normal mix for the long-run portfolio. Tactical asset allocation (TAA) is the portion of the portfolio designed to profit from temporaty market disequilibria. State False or True.

True SAA is the asset mix that is intended to accomplish investment objectives over the long run. TAA is designed to deviate from SAA when temporary market conditions make it profitable to do so.

The previously mentioned solution of selling off the asset would not work if the client does not want to part with the asset and/or the transaction may incur significant capital gains taxes. Some options available to people with concentrated portfolios are:

-Selling by installments, -Placing the asset with a third party who in turn gives the client a diversified portfolio as a loan; the third party will either sell the asset off by installment or to keep it for their inventory, and -Use options to hedge or lock into a sale position.

The obvious directive for an investment manager would be to rebalance the portfolio by selling the portion of the asset greater than what is appropriate for the client and purchase a diversified portfolio that fits his or her needs. However, several problems may arise from this solution:

-The client may not want to part with the asset. -There may not be any demand for this asset. -There is an enormous capital gain on the asset.

The standard deviation of variable X is 0.20. The standard deviation of variable Y is 0.12. The covariance between X and Y is 0.0096. What is the correlation between X and Y? 0.20 0.36 0.40 0.24

0.40 0.0096 / (0.20 x 0.12) = 0.40

The following are steps for phase 1 of the asset allocation process:

1. Gain understanding of client's financial position, goals, constraints, and the investor's preferences in a risk-return context. 2. Develop realistic expectations by educating investor of advantages and disadvantages of various investment strategies and styles. 3. Create a statement specifying the goals and policies that will be used in managing the client's funds.

If a security has a beta of 1.5, how much will it move if the market rises or falls by 10%? 15% 150% -45% 5% 50% 10%

15% The security is 50% more volatile. 1.5 x 10% = 15%

Tom Harmon asks you what would be a good portfolio to own? A portfolio with a correlation coefficient of zero A portfolio with a high coefficient of variation A perfectly positively correlated set of securities A portfolio with a high covariance

A portfolio with a correlation coefficient of zero A perfectly positively correlated set of securities would have the maximum risk. A portfolio with a high covariance would probably also have a high correlation coefficient. A portfolio with a high coefficient of variation is risky. Most investors would like a portfolio with a correlation of zero. Standard deviation (risk) would be greatly reduced.

The asset allocation decision: A. Involves selecting the classes of assets in which funds will be invested. B. Should focus on selecting assets that are expected to offer the highest return over the investment horizon. C. Refers to the decision on what specific securities the funds should be used to purchase. D. Should be strictly adhered to throughout the investment horizon in order to maintain a well-diversified portfolio.

A. Involves selecting the classes of assets in which funds will be invested. The asset allocation decision involves selecting the classes of assets, rather than the specific securities, in which to invest. It needs to be based on the objectives and constraints of the investor, which may not be investing to offer the highest expected return. It must be revisited regularly to ensure that the objectives and constraints are still being met and to make any necessary changes if the objectives and constraints are modified due to changes in the investor's circumstances.

Phase 2: Managing the Money

After the written policy statement is complete, the planner and the client can reduce the frequency of their meetings. During Phase 2 of the asset allocation process, the planner returns to his or her office to manage the money. In a large asset allocation firm, someone different than the person who manages the money in Phase 2 may gather information in Phase 1 of the asset allocation process.

Step 5: Allocating Assets

An investment manager begins Step 5 by reviewing the client's policy statement created at Step 3 to achieve the investment target in mind. Next, the manager considers the expected risk-and-return statistics created in Step 4 to obtain the input data needed to allocate investment money to asset classes. If the world's capital markets are in equilibrium, the investment manager can follow the strategic asset allocation (SAA). SAA is also called policy asset allocation, the normal asset mix, and the long-run asset allocation. If the investment manager perceives that the market is not in equilibrium, then the he or she may make a tactical asset allocation (TAA) that deviates from the SAA. If the investment manager produced clear, meaningful dynamic asset guidelines at Step 3 of the asset allocation process, he or she will provide boundaries on how far the TAA is permitted to deviate from the client's SAA.

Asset Allocation Process

Asset allocation focuses on determining the mixture of asset classes that will provide a combination of risk and return that is optimal given an investor's financial situation and investment objectives. An asset class is a grouping of securities with similar characteristics, such as stocks, bonds, and money market instruments. The asset allocation process should begin with the development of a strategic asset allocation (SAA). SAA identifies asset classes and the proportions for those asset classes that would comprise the normal portfolio mix. Tactical asset allocation (TAA) comes after SAA, as it involves planning for deviations from normal asset allocation. TAA establishes policies to govern dynamic reallocations of a temporary nature. After the SAA and TAA plans are complete, market timing or security selection may be integrated into the plans. However, investors cannot begin working on the SAA and TAA plans until a policy statement, listing the objectives of the investor, is created.

Dynamic Asset Allocation Guidelines:

At the sole discretion of the money manager, the strategic proportions (long-run normal mix) allocated to any major asset category may be temporary values indicated by the ranges in the table above. Such tactical asset allocations should be used to exploit short-run market disequilibria that may emerge.

the parts of the policy statement include:

Benchmark Constraining Policies Asset Allocation Policies Panic Attack

Using Beta to Understand a Stock's Risk

Beta is a measurement of market risk or volatility. That is, it indicates how much the price of a stock tends to fluctuate up and down compared to other stocks.

Dynamic Asset Allocation

Change in weight to meet a change in investors circumstances

Tactic Asset Allocation

Change in weights to meet temporary market conditions

Change and Feedback

Changes in the amount of the client's assets, changes in the client's risk-return preferences, or other factors may require the client and the investment manager to prepare a new policy statement. The client and the manager should always be prepared to return to Step 1 of the asset allocation process. In addition, it may become necessary to upgrade the client's education, stimulate communications, and nurture trust between the client and the investment advisor.

What Is Covariance?

Covariance measures the directional relationship between the returns on two assets. A positive covariance means that asset returns move together while a negative covariance means they move inversely. Covariance is calculated by analyzing at-return surprises (standard deviations from the expected return) or by multiplying the correlation between the two random variables by the standard deviation of each variable.

Tim owns two stocks (Companies A and B). Company A has just completed an acquisition of Company C. The standard deviation of stock A was unchanged by the acquisition. How will the covariance of two stocks (A and B) be affected if the new Company C is negatively correlated to Companies A and B? Unchanged Becomes positive Increased Becomes negative Decreased

Decreased The covariance has a direct relationship to the correlation coefficient. The new acquisition is negatively correlated with both Company A and B. That should reduce the covariance but not necessarily make it negative. It depends on the weighting of company A and B. A is weighted at 40% and B is weighted at 40%. They are highly correlated. So C is negatively correlated but it is only 20%. The weighting is still positive. The standard deviation formula uses weighting.

Strategic Asset Allocation

Derive long-term asset allocation weight

When is goal setting done?

During the entire interview process.

Discussions about deviations from the normal SAA asset mix provide a good opportunity for the investment manager to educate the client about different asset allocation strategies beyond SAA and TAA:

Dynamic Asset Allocation (DAA) refers to alterations in the asset weights made in response to changes in the investor's circumstances and/or changes in the market conditions. TAA is one type of DAA. Integrated Asset Allocation considers the investor's goals and policies and the capital market conditions, and then uses these data as inputs to some kind of optimizer. The optimizer could be some mathematical formula (constant proportions), or an optimizing computer program to do Markowitz portfolio analysis. The optimizer's solution becomes the new inputs that are reconsidered along with the investor's latest goals and policies and most recent market conditions when revising the asset allocation.

If you wanted to purchase a mutual fund that would have the lowest correlation with a U.S. common stock fund, which fund would you select? European fund Emerging markets fund Japan fund International fund Global fund

Emerging markets fund The correlation coefficient between the U.S. market and an emerging markets fund is low. Emerging markets: Less developed countries Global: World (including US) International: Non-U.S./foreign only

Missing E(r) Goal

Experienced investors know not to get excited about short-term returns that fluctuate above and below the long-run expected return (SAA goal). Neophyte investors need to be educated when they start observing short-term returns that fluctuate randomly. This is the mean reversion process. Mean reversion is a process whereby security returns tend to fluctuate randomly in the short run but tend to revert back to their long-run means after attaining extreme values. Financial economists debate about mean-reversion in security returns. Explaining mean reverting returns is an effective way for an investment manager to help the client understand why the quarterly returns rarely hit their expected (long-run mean) rate of return.

Liquidating Old Assets

Few clients will arrive at the planner's office with all their assets in cash. Most clients already have an assortment of investments and they are often reluctant to liquidate them. Some investors are reluctant to admit past mistakes and realize their losses; some investors erroneously believe that their tax-deferred investments (IRAs, Keogh plans, 401k plans) cannot legally be liquidated; some are emotionally attached to investments they cannot justify on an economic basis; some investors think they have an asset (a potential "winner") about to begin a period of lucrative price appreciation; and some investors do not have enough confidence in their investment manager. Any of these circumstances require the planner to work to gain the client's trust and to educate the client.

Which of the following is true? A negative correlation coefficient will reduce the portfolio risk. A negative correlation coefficient will increase the portfolio risk. A negative correlation coefficient will make the beta negative. A negative correlation coefficient will increase the portfolio standard deviation. I II, IV II, III I, III III, IV

I, III A negative correlation will reduce the portfolio beta. The formula for beta includes the correlation coefficient. When it is negative, the beta will be negative.

Which of the following assets are liquid? I. Growth fund II. CD maturing shortly III. Life insurance cash value IV. Government bond fund V. Money Market fund II, III, V I, III, V II, IV I, IV, V

II, III, V Liquid assets are convertible into cash without significant loss of principal (absent new information). The CFP Exam may force you to choose short-term maturity CDs, laddered CDs, or life insurance cash value. In this question, Answer V cannot be chosen as a stand-alone answer. Because they are not sold in the open market, open-end mutual funds are not liquid. NOTE: Open-end money market mutual funds are an exception to the rule. They are considered liquid. Closed-end funds, ETFs, and brokered CDs are generally not considered liquid (possible loss of principal).

Which of the following assets is/are marketable? I. Savings/Checking accounts II. Money Market accounts III. Treasury bonds IV. Common stock V. Mutual funds II, V IV I, II, V III, IV

III, IV Savings/checking/money market accounts and mutual funds are redeemed. Therefore, they are not marketable. After original issue by the Treasury, marketable securities can be bought and sold in the financial marketplace, and ownership is transferable. Marketable securities include Treasury bills, notes, bonds and Treasury Inflation-Protected Securities (TIPS). REITs, closed-end funds, ETFs and brokered CDs are considered marketable. Marketability is the speed and ease with which a security may be bought or sold regardless of price fluctuations. Assets are marketable if they can be bought or sold; they are not marketable if they must be redeemed through the issuer rather than through other investors. A market does not have to be physical (like the NY Stock Exchange). It can be virtual (for example, the NASDAQ) or metaphorical (for example, the real estate market).

Individual Stock Selection

If a manager begins with sector selection, then stock selection, then he or she is employing a top-down investment approach. If the manager begins by identifying the securities he or she wants in the portfolio first, then the manager is using a bottom-up approach. * Think corporate at the top then little people at the bottom

Large Transaction

If the client is a very wealthy individual or an institutional investor, it might be wise to retain the services of a securities trading firm that specializes in executing large transactions. For example, if 100,000 or more shares of a NYSE-listed stock or 10,000 or more shares of a stock traded only in an emerging nation's securities market are to be traded, the transactions costs could become extremely high unless the transaction is handled by experienced traders. Small transactions usually have no market impact. Market impact costs arise because large sales tend to depress the security's market price and large purchases tend to bid up its price. Very large transactions can have surprisingly large execution costs because the market impact cost of the transaction can exceed the commission costs. Furthermore, if the money manager can give the trader several days to "work the order," that time can be used to reduce the execution cost of a large transaction.

Step 6: Investing the Allocation Funds

If the money manager invests in actively traded stocks, problems are rare. The money manager simply gives the order to a reputable broker who provides rapid executions and charges low transaction costs. The trade should be confirmed in moments. However, if the client owns assets that must be liquidated to make a new asset allocation, or if the client wants to make a multimillion-dollar investment, then Step 6 becomes a more important part of the asset allocation process.

Step 1 of financial planning process: Gain Understanding

In the first step of the financial planning process, a relationship is established between you and the client. During this step, the client must disclose sensitive personal information about his or her finances. It is important for you to establish a rapport that will make your client comfortable and confident in sharing this information with you. If your clients withhold information from you, it will be difficult for you to help create a financial plan that has the correct asset allocation to help them reach their goals. Individual investors must be willing to reveal intimate facts to their money manager about their age, education, work experience, health, and details about their family and personal life. There is a wide array of goals and constraints that are appropriate for the investments of different types of investors. An important part of the money management processes is to continue discussions with the client to stay abreast of any changes that might occur. In the initial discussions it is important that you and your client discuss: The client's financial situation, The length of the client's investment horizon, The client's tax situation, Any legal constraints that might be binding on the client's investing activities, Anticipated cash withdrawals or deposits, and The client's liquidity needs.

An asset allocation strategy that gives simultaneous consideration to the investor's goals and policies and capital market conditions and uses these data as inputs to an optimizer is known as: Insured asset allocation Dynamic asset allocation Integrated asset allocation Strategic asset allocation Tactical asset allocation

Integrated asset allocation Integrated asset allocation considers the investor's goals and policies and capital market conditions, and then uses these data as inputs to some kind of optimizer. The optimizer's solution becomes the new inputs that are reconsidered along with the investor's latest goals and policies and most recent market conditions when revising the asset allocation.

Which of the following is a disadvantage of investing internationally? Investors in foreign stocks can be taxed twice; once in the country of origin and once in the United States. International markets are more efficient than U.S. markets. International stocks have low correlations with U.S. stocks. International funds do not have exchange rate risk because of U.S. stock holdings.

Investors in foreign stocks can be taxed twice; once in the country of origin and once in the United States. The question asked for the disadvantage.

The asset allocation decision: Involves selecting the classes of assets in which funds will be invested. Should focus on selecting assets that are expected to offer the highest return over the investment horizon. Refers to the decision on what specific securities the funds should be used to purchase. Should be strictly adhered to throughout the investment horizon in order to maintain a well-diversified portfolio.

Involves selecting the classes of assets in which funds will be invested. The asset allocation decision involves selecting the classes of assets, rather than the specific securities, in which to invest. It needs to be based on the objectives and constraints of the investor, which may not be investing to offer the highest expected return. It must be revisited regularly to ensure that the objectives and constraints are still being met and to make any necessary changes if the objectives and constraints are modified due to changes in the investor's circumstances.

Long-Run Objective:

Maintain a low exposure to risk (small standard deviation of returns), while earning a single-digit long-run average annual rate of return.

Constrained Asset Allocation

Many investors have no control over a significant portion of their investment portfolio. For example, investors may have no discretion over assets in pensions provided by their employers. Such non-discretionary pensions comprise a large part of many individual investors' portfolios. Likewise, endowments and foundations sometimes receive gifts from benefactors that specify how the benefactor wants the donation invested. Although these assets are desirable, they might also represent less than optimal asset allocations. When operating under external constraints, the investment manager must investigate the makeup of the non-discretionary assets before allocating the discretionary portion of the funds. Situations involving major constraints sometimes lead to surprising investment advice from the planner. For example, consider a client who confides in her planner that she wants to avoid foreign investments, but 90% of this client's assets are already invested in domestic assets by her employer-managed pension fund. Then, in spite of the client's previously stated wishes, the planner might suggest investing all of the remaining 10% of the assets that are discretionary in foreign securities. To make an asset allocation recommendation like this, the planner would have to spend time educating the client and gaining her trust.

Using multiple asset classes in an investment portfolio reduces which of the following risks? Credit Interest rate Market Liquidity

Market Diversification will reduce market risk due to low correlation.

Along with identifying certain characteristics of securities, financial analysis also attempts to identify which of the following? Economic fundamentals of the market Forecast of securities values Mis-priced securities Under-priced securities

Mis-priced securities Financial analysts are active mangers who focus their research efforts on analyzing company financial statements. Such research permits an analyst to better understand a company's business operations, as well as the characteristics of securities, group of securities, and which securities might be mis-priced.

Which of the following investments would you recommend for your client's liquidity needs? High Yield Bonds Foreign Stock Shares of a Partnership Money Market Fund Land

Money Market Fund Liquidity needs such as emergency funding or a temporary place to hold some money must be met by liquid asset. Money market mutual funds are the most liquid investments in the list. The low eating of the high yield bond makes it tough to sell. Foreign stocks may be harder to sell than domestic ones, especially from emerging markets. Land and shares to a partnership are typically classified as illiquid investments as well.

Rebalancing

One way to ensure asset allocation is continuously updated in accordance to the client's risk tolerance and time horizon is to periodically rebalance the portfolio. There are two typical situations that require rebalancing: Time: As time goes by, the investor's time horizon will shorten. The closer to the time horizon the more conservative the portfolio should be. It is similar to driving on the highway: As a driver approaches an exit, he or she will move from the faster lanes to the slower lanes before ultimately taking the off-ramp. Performance: As the performance of the securities changes, the asset allocation may change accordingly. For example, in the late 1990s, stocks, especially tech stocks, did exceptionally well. Their increased value will skew the stock portion of the portfolio above the original asset allocation proportions. To rebalance the portfolio, an investor may sell off the excess proportion of the stock portfolio and purchase the other asset classes until the asset allocation is back to the original proportions.

Integrated Asset Allocation

Optimized based on investment goals and market conditions

Step 7: Performance Reports and Feedback

Performance reports showing the current market value of each asset and the aggregate value of the portfolio are typically prepared for the client on a quarterly basis. These reports usually cause two problems for investment managers with inexperienced clients. 1. If the investment manager is involved in a dynamic strategy, the TAA weights and the SAA weights will differ. 2. When the portfolio's return over the last three months is annualized and compared to its long-run expected annual return, it will almost always differ from the long-run goal. These two deviations from the written policy statement must be explained if the client does not already understand why they occur.

What are the steps and phases of the asset allocation process?

Phase 1: Written Policy + steps 1, 2 and 3 Step 1: Gain Understanding Step 2: Expectations Step 3: Policy Statement Phase 2: Managing the money + steps 4-7 Step 4: Forecasting Step 5: Allocating Assets Step 6: Investing the allocation funds Step 7: Performance reports and feedback

One stage security selection process

Portfolio managers will make forecasts of expected returns, standard deviations, and co-variances for all available securities. These forecasts will allow an efficient set of portfolios to be generated, upon which the indifference curves of the client can be plotted. A portfolio that sits on both the efficient set and the client's indifference curve is the one most suitable for the client. This is called a one-stage security selection process. In the one-stage selection process excessive costs would be incurred to obtain detailed forecasts of the expected returns, standard deviations, and co-variances for all the individual securities under consideration. In practice, this is rarely done. Instead, the decision on which securities to purchase is made in two or more stages.

How is a benchmark portfolio used in an investment policy? Click all that apply. Reference point for risk objectives Security selection Measure performance against Reference point for return objectives Diversification

Reference point for risk objectives Measure performance against Reference point for return objectives Funds are professionally managed based on a previously determined strategy. Investors do not get to choose which securities should be purchased or sold.

Phase 2: Managing the Money:

Requires the investment manager to manage the client's money. This phase begins with the preparation of needed forecasts. Then the investment funds are allocated to asset classes and the appropriate investment orders are executed. This phase ends with a periodic performance report. The investment manager and the client discuss the performance report and, if necessary, update the written policy statement.

Phase 1: Written Policy:

Requires the planner and the client to work together to create a written policy statement. The policy statement guides the remainder of the asset allocation process, and it furnishes a standard against which the performance of the investment manager can be evaluated.

Which one of the following is a component of the investment process that involves identifying which securities to invest in and determining the proportion of funds to invest in each of the securities? Investment policy Security selection Portfolio revision Portfolio evaluation

Security selection Security selection is a component of the investment process where assets are identified for investment and the proportion of funds to invest in each of the assets is determined. The investment manager makes a forecast of expected returns, standard deviations, and co-variances for all available securities. This results in the identification of the optimal portfolio.

Different components of asset allocation include:

Simple Asset Allocation Constrained Asset Allocation Markowitz Portfolio Theory Selecting Efficient Asset Allocation

Concentrated portfolios

Some people actually seek concentrated portfolios as an investment. Concentrated portfolios only hold a few securities. If you compare a portfolio made up of twenty stocks versus one that holds 160 stocks, obviously the smaller portfolio will have less diversification. Also, it would be harder to define a benchmark index for such a portfolio. The small portfolio's return will likely have less correlation to the markets compared to the larger portfolio. So what are the benefits of a concentrated portfolio? First, it would take less money to create. Also, the bet is the portfolio manager is better at picking the best 10-20 stocks than coming up with the best 100. If index investing is considered to produce average returns, then a concentrated portfolio is aiming for the complete opposite. The ultimate decision for this type of strategy rests on the ability of the portfolio manager. Concentrated mutual funds may have a very high initial investment limit. Also, if the manager turns over the portfolio frequently, the investor will end up with higher short-term capital gains and expenses. Again, when creating a portfolio, there can be a portion that is passive, and a portion that is concentrated.

What is the term used to describe the risk where all securities tend to move in the same fashion? Financial risk Systematic risk Overall risk Unsystematic risk

Systematic risk Market risk and systematic risk are synonymous.

This analysis attempts to predict short-term price movements and makes recommendations concerning the timing of purchases and sales of stocks. Fundamental Technical Bottom-up Top-down

Technical Technical analysis is involved with short-term predictions of security price movements based on past patterns of prices and trading volumes, and then makes recommendations concerning the timing of purchases and sales of stocks.

In passive management, the securities are already identified by the benchmark index. In active portfolio management, techniques for selecting stocks can be divided between two schools of analysts:

Technical analysis involves short-term predictions of security price movements based on past patterns of prices and trading volumes. Fundamental analysis concerns estimates of the basic determinants of security values, such as future sales, expenses, and earnings for firms. There is a focus on analyzing company financial statements. Such research permits an analyst to better understand a company's business operations, its plans for future growth, what factors affect its profitability, and how those factors affect its profitability.

Analysts who study historical market data in hopes of finding patterns that will repeat themselves in the future are known as: Risk-return analysts Technical analysts Graphic analysts Fundamental analysts Pattern analysts

Technical analysts Technical analysts study historical market data. They prepare graphs of stock prices and study statistics in hopes of discerning patterns that will repeat themselves in the future. Technical analysts typically analyze dozens of different assets and market indexes, but they typically prepare their forecasts for one asset or one market index at a time.

Step 3: Policy Statement

The client and the planner need to work together to create a written policy statement that carefully sets forth the investment goals and policies. This document provides continual guidance through the asset allocation process and is equally important to the planner in managing the investments. Committing the policy statement to paper forces the writer to think about goals that might conflict or are not clearly formulated. A written statement provides consistent guidance during stressful periods and can also be used as a performance standard. These are the parts of the policy statement: Benchmark Constraining Policies Asset Allocation Policies Panic Attack

What Is the Correlation Coefficient?

The correlation coefficient is a statistical measure of the strength of the relationship between the relative movements of two variables. The values range between -1.0 and 1.0. A calculated number greater than 1.0 or less than -1.0 means that there was an error in the correlation measurement. A correlation of -1.0 shows a perfect negative correlation, while a correlation of 1.0 shows a perfect positive correlation. A correlation of 0.0 shows no linear relationship between the movement of the two variables.

Tax situations

The long-term capital gains tax is levied for investments held for over one year if the proceeds exceed the purchase price. The maximum tax rate for long-term investments is 20%. Short-term capital gains taxes are for investments held for one year or less than one year and are taxed as part of investor's income. If there was a net loss, then it can be deducted, up to $3,000 per year. If the amount of the loss is greater than $3,000, then the investor can carry that amount to future tax years, and continue to deduct up to $3,000 per year.

Every The Markowitz Efficient Frontier efficient portfolio generated has:

The maximum expected return available at its level of risk, and The minimum risk at its level of expected return. In Step 5 of the asset allocation process, the money manager selects one efficient portfolio that aligns with the investment preferences set forth in the client's policy statement.

Portfolio Diversification:

The portfolio manager will first find a portfolio that has the expected return and risk that matches the client's needs. Asset allocation is then applied to diversify between asset classes. The security selection process can be a passive management approach, one of a number of active management strategies, or a blend of different strategies.

Risk Tolerance

The starting point in making such estimation is to provide the client with a set of risks and expected returns for different combinations of two hypothetical portfolios. Note that the investor is being presented with the efficient set that arises when there is a set of stocks and a risk-free borrowing and lending rate. This efficient set is known as the Capital Market Line (CML) and is linear, meaning that it is a straight line that emanates at the risk-free rate and goes through a tangent portfolio that consists of a certain combination of securities. At this point, the client is asked to identify the combination that appears to be most desirable, in terms of expected return and standard deviation. Asking the investor to identify the most desirable combination is equivalent to asking the investor to locate where one of his or her indifference curves is tangent to the linear efficient set. This point will represent the most desirable portfolio.

Selecting an Efficient Asset Allocation

To complete Step 5 the money manager selects one of the optimal portfolios on the efficient frontier. The efficient portfolio that is selected should align with the goals and policies written down at Step 3. If the client is extremely risk-averse or needs completely liquid investments, then the optimal portfolio will be at the lower end of the efficient frontier (heavily invested in U.S. Treasury bills). If the client is aggressively seeking to maximize the expected return, all the client's funds might be invested in common stocks at the high-risk end of the efficient frontier.

One way to define a client's investment needs is to use lifecycle asset allocation:

This method of asset allocation attempts to address the client's portfolio asset allocation based on the typical needs of a person in a similar lifecycle stage. The idea is that in the earlier lifecycle stages, an investor may have more long-term investment objectives and can tolerate more aggressive investments. As the investor approaches later lifecycle stages, his investment objectives are either shorter or immediate. At that point, his portfolio should become more conservative. Investors can work with planners to manually assign the allocation according to their lifecycle stage, or invest in lifecycle mutual funds. The portfolio allocation will move from an equity dominate mix to a fixed income securities dominate mix as the investor advances in age.

Some additional topics that you can discuss with your clients to set expectations are:

What is realistic and achievable, The scope of what the portfolio will attempt to accomplish, The positive relationship between risk and return, Market volatility, and The extreme difficulty and low success rate of market timing.

When are two investments perfectly positively correlated? When the correlation coefficient is +1.0 When the correlation coefficient is 0.0 When the covariance is +1.0 When the covariance is -1.0

When the correlation coefficient is +1.0

Can a client have more than one time horizon? Yes No

Yes. A client could have multiple investment goals, each with its own time horizon. For example, in creating a financial plan, you may discover that your client wants to retire in 35 years, pay for her son's college education in 18 years, and buy a new home in 5 years. Each of these is a different goal carrying a different time horizon.

The third and final stage makes this allocation and is referred to as

asset allocation. Active and passive management may be used in any stage.

Brad has tried various strategies of trading stocks through the years. Sometimes he was successful and sometimes he was terribly wrong. He finally felt he could not justify and switched to buy and hold. He turned... to believe in EMH. from active to passive. to believe in the CML principals. to believe in the efficient frontier.

from active to passive. The question never quotes EMH concepts.

The Asset Allocation Process

is comprised of two phases: the written policy phase and the money management phase. The investment manager is required to meet the client and discuss issues regarding investment objectives, risk-return preferences, goals, time horizon, and asset allocation.

Total risk is measured by ___________ which is a measure of ___________.

standard deviation + VARIABILITY

In the second stage, known as sector rotation

the investment manager determines the appropriate combination of sectors within each asset class. Similarly, the manager may have decided that the appropriate combination of bonds is 100% in long-term, with nothing in either intermediate-term or short-term bonds. Thus, in this stage, the manager will determine the composition of an optimal stock portfolio and an optimal bond portfolio but will not know how much to allocate to each one.

In the first stage of sector selection

the investment manager would exercise discretion in identifying sectors of securities in each asset class. Then, having identified the sectors, the investment manager would determine the optimal portfolio for each one. Within the asset class of bonds, sectors of long-term, intermediate-term, and short-term bonds have been identified. Then, the investment manager would proceed to identify several optimal portfolios, one for each sector of securities.

In a two-stage security selection procedure

the portfolio manager considers which common stocks and corporate bonds to invest in for a client. The expected returns, standard deviations, and co-variances are forecast for all common stocks under consideration. Then, on the basis of just these common stocks, the efficient set is formed and the optimal stock portfolio identified. Next the same analysis is performed for all corporate bonds under consideration, resulting in the identification of the optimal bond portfolio.