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FORUN Technology Research and Advisory ___________________________________________________________________________ |
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Asset Allocation Professional portfolio managers seek to achieve the best possible trade-off between risk and return. Though different managers have different styles, many of them follow a similar two-step management approach: They first decide the proportion of the overall portfolio to place in safe but low-return money market securities versus risky but higher return securities like stocks. The choice of the fraction of funds apportioned to risky investments, a broad asset classes like stocks, bonds, real estate, foreign assets, and so on, is called asset allocation. They then decide particular securities to hold within each asset class, a process called security selection. Investors who do frequent asset allocation revisions are called market timers. For instance, they may put more funds in treasury when they believe that stock prices are heading down. Similarly, they are likely to put more money in stocks if they believe that stock prices are heading up. It is common practice to view Treasury bills as the risk-free asset. The short term nature of Treasury bills makes their values insensitive to interest rate fluctuations. Moreover, the inflation risks over the short term of a few weeks or months is negligible compared to the stock market returns. In addition, the Treasury bills are essentially default-free because the government has the power to tax and control money supply. We are assuming here that the investor is building a simple portfolio of two assets: a risky stock index and the risk-free treasury. The asset allocation problem is thus simplified as deciding the risk-return trade-off between the risky stock index and the risk-free treasury. The optimal mix of the two assets in this simple portfolio is determined by investor’s risk aversion: maximizing a utility function that is a combination of the expected portfolio rate of return and the investor’s aversion for the variance of the portfolio rate of return. 1. Scenarios: select the stock index. The past performance of the stock index is used as the starting point for future index performance. 2. Expected Return: the expected rate of return for the stock index. The initial number is the annual return from past performance. The data is updated to end of August 1999. Change to your expectations. Enter 20 if it is 20%. 3. Expected Sigma (%): the expected volatility in the stock index rate of return. The initial number is the annual volatility from past performance. The data is updated to end of August 1999. Change to your expectations. Enter 30 if it is 30%. 4. Future expected as: confirm your choice in step 1. 5. Risk Free Rate %): It is the expected future rate of return for the Treasury. Enter 5 if it is 5%. 6. Risk aversion: for the majority of investors, the risk aversion is between 2 and 4. The higher the number, the more the risk aversion. Zero is not accepted. 7. % in Treasury: here is the fraction to invest in Treasury. Negative numbers means borrowing or buying the stock index on margin. 8. % in stock: here is the fraction to invest in stock index. A faction higher than 100% means buying the stocks on margin. 9. Portfolio return: annualized rate of return for the simple portfolio of stock index and risk-free asset. 10. Portfolio volatility: annualized volatility for the simple portfolio of stock index and risk-free asset. 11. Return Vol. Ratio: the ratio of annualized rate of return to the annualized volatility in the rate of return for the simple portfolio. |
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