💲Intro to Investments Unit 3 – Asset Allocation & Portfolio Diversification

Key Concepts

• Asset allocation involves dividing an investment portfolio among different asset categories (stocks, bonds, cash)
• Portfolio diversification spreads investments across various financial instruments, industries, and asset classes
  • Aims to maximize returns by investing in different areas that would each react differently to the same event
• Risk tolerance measures an investor's ability to handle declines in the value of their portfolio
  • Factors include investment goals, age, and financial stability
• Modern Portfolio Theory (MPT) is a framework for assembling an asset portfolio that maximizes expected return for a given level of risk
• Correlation measures the relationship between the movement of two variables (asset classes)
  • Ranges from -1.0 (perfect negative correlation) to 1.0 (perfect positive correlation)
• Rebalancing is the process of realigning the weightings of a portfolio by periodically buying or selling assets to maintain the original desired asset allocation

Types of Assets

• Stocks represent ownership in a company and provide potential for capital appreciation and dividend income
  • Carry higher risk and volatility compared to bonds
• Bonds are debt securities that pay regular interest and return the principal at maturity
  • Generally less risky than stocks but offer lower potential returns
• Cash and cash equivalents (money market funds, Treasury bills) offer liquidity and stability
  • Provide minimal returns but protect against market downturns
• Real estate includes direct ownership of property or investment through Real Estate Investment Trusts (REITs)
  • Offers potential for rental income, capital appreciation, and diversification
• Commodities are physical goods (gold, oil, agricultural products) traded on exchanges
  • Prices driven by supply and demand; can provide inflation protection
• Alternative investments include hedge funds, private equity, and venture capital
  • Less regulated and less liquid than traditional assets; higher risk and potential returns

Risk and Return Basics

• Risk is the chance an investment's actual return will differ from the expected return
  • Measured by standard deviation; higher standard deviation indicates greater risk
• Return is the gain or loss on an investment over a specified period, including capital appreciation and income
• The risk-free rate is the theoretical rate of return on an investment with zero risk (usually based on government securities)
• Systematic risk (market risk) affects the entire market and cannot be diversified away
  • Includes interest rate changes, recessions, and wars
• Unsystematic risk (specific risk) is unique to a specific company or industry and can be reduced through diversification
  • Includes management changes, labor strikes, and technological obsolescence
• The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets
  • Expressed as: $r_a = r_f + β_a(r_m - r_f)$

Portfolio Theory

• Modern Portfolio Theory (MPT) is a mathematical framework for assembling a portfolio of assets to maximize expected return for a given level of risk
• Efficient frontier is a set of optimal portfolios that offer the highest expected return for a given level of risk
  • Portfolios below the efficient frontier are sub-optimal (too much risk for the level of return)
• Investors are risk-averse; they will only take on increased risk if compensated by higher expected returns
• Diversification is a key concept of MPT; spreading investments across different asset classes can reduce portfolio risk
• Optimal portfolios are a combination of a risk-free asset and a risky asset portfolio on the efficient frontier
• The Sharpe ratio measures risk-adjusted return; the average return earned in excess of the risk-free rate per unit of volatility
  • Calculated as: $(r_p - r_f) / σ_p$

Diversification Strategies

• Diversification involves investing in a variety of assets to reduce the impact of any one investment on the overall portfolio
• Asset class diversification spreads investments across different asset classes (stocks, bonds, real estate)
  • Each asset class has different risk and return characteristics
• Sector diversification invests in different sectors of the economy (technology, healthcare, energy)
  • Sectors may respond differently to market conditions and economic cycles
• Geographic diversification invests in different countries or regions (U.S., Europe, emerging markets)
  • Provides exposure to different economic and political environments
• Style diversification includes different investment styles (value, growth, small-cap, large-cap)
  • Styles may outperform at different times based on market conditions
• Time diversification involves investing at regular intervals over time (dollar-cost averaging)
  • Reduces the impact of market volatility by buying more shares when prices are low and fewer when prices are high

Asset Allocation Models

• Strategic asset allocation sets target allocations for each asset class based on long-term goals and risk tolerance
  • Allocations remain constant regardless of market conditions
• Tactical asset allocation allows for short-term deviations from target allocations to take advantage of market opportunities
  • Requires active management and market timing skills
• Dynamic asset allocation automatically adjusts allocations based on market conditions or the investor's age
  • Target-date funds become more conservative as the target date approaches
• Core-satellite approach combines a core portfolio of traditional assets with smaller allocations to specialized or high-risk satellite investments
• Risk parity approach allocates assets based on risk contribution rather than capital allocation
  • Aims to equalize the risk contribution of each asset class
• Factor-based asset allocation focuses on exposure to specific risk factors (value, momentum, size)
  • Seeks to capture risk premiums associated with each factor

Practical Application

• Determine investment goals and risk tolerance before creating an asset allocation strategy
• Consider time horizon, liquidity needs, and tax implications when selecting investments
• Use index funds or exchange-traded funds (ETFs) for low-cost, diversified exposure to asset classes
  • Avoid trying to pick individual stocks or time the market
• Rebalance portfolio periodically (annually or when allocations deviate significantly from targets)
  • Sell assets that have become overweighted and buy assets that are underweighted
• Monitor portfolio regularly and adjust as needed based on changing goals or market conditions
• Seek professional advice from a financial advisor for complex situations or large portfolios

Advanced Topics

• Black-Litterman model is an asset allocation model that combines market equilibrium with the investor's views
  • Allows for subjective input and provides a more stable and diversified portfolio
• Monte Carlo simulation is a technique that generates random variables to model risk and uncertainty
  • Can be used to stress-test portfolios and estimate probabilities of outcomes
• Post-modern portfolio theory (PMPT) is an extension of MPT that considers downside risk and investor preferences
  • Uses value at risk (VaR) and conditional value at risk (CVaR) as risk measures
• Behavioral finance studies the influence of psychology on investor behavior and market outcomes
  • Identifies biases (loss aversion, overconfidence) that can lead to suboptimal investment decisions
• Environmental, Social, and Governance (ESG) investing considers non-financial factors in the investment process
  • Aims to align investments with personal values and promote sustainable business practices
• Robo-advisors are digital platforms that provide automated, algorithm-driven financial planning services
  • Often use MPT-based asset allocation models and low-cost index funds