Chapter 11 – Diversification & Allocation Concepts Winter 2011 Fin / Invest / Business Law Cluster Kevin C. Kaufhold 1

Diversification noted briefly, text, at 381 --- “Don’t put all your eggs in one basket” Is process of choosing assets with dissimilar risk-return characteristics Can reduce or eliminate firm-specific “unique” risk Leaves only systematic risk felt by an entire asset market Maintains return, but minimizes risk to market-level volatility May be the closest thing there is to a “free lunch” 2

How many assets are need to be diversified? Some recent studies suggest 50 – 75 securities (Picerno, 2002) Older studies / commentary suggested as few as 10 to 30 securities (Graham, 1934; Dreman, 1998) Following graph shows power of diversification (Kaufhold, 2009) 3

4

Adding international assets can reduce risk to WORLD-WIDE systematic levels (Kaufhold, 2009) 5

Firm-level risk can be eliminated by diversification --- But what about market-level risk? Cannot eliminate systematic risk But can at least manage it through a process known as --- 6

Asset Allocation, text, a 381 – 386 AA is a financial plan for dividing or allocating money between different asset classes Emphasis is on preserving capital (e.g. Thinking Patterns paper) AA is not a plan to buy or sell individual assets AA IS a plan to allocate % of portfolio across asset classes Why do we allocate????? 7

Most of a portfolio’s risk-return structure comes from allocation across asset classes And NOT individual asset selection Up to 90% of return variability (i.e. risk) of a portfolio comes from the allocation decision (Brinson, Hood, and Beebower, 1986) Only 10% comes from individual assets 8

Allocate between Stocks, Bonds, Cash And possibly, RE and other alternative assets But, what percentages? text, at 381 – risk tolerances holding period net worth age family factors Many other social and economic influences

“Average” AA, text, at 382 --- Stocks, stock funds ----- 57% Bonds, bond funds ----- 16% Cash, ST near-cash ---- 27% Total ----------------------- 100% This is fairly aggressive, but with lots of ST cash needs

A more “balanced” AA, with some ST cash needs --- Stocks ------ 50% Bonds ------ 30% Cash -------- 20% “Balanced” AA, with few ST cash needs (rainy day fund) Stocks ------ 50% ---- 55% Bonds ------ 40% ---- 35% Cash -------- 10% ---- 10%

As your exposure to equities increase Volatility (i.e. risk) increases But “expected” return also increases Higher risk, higher return Maintain AA percentages To preserve capital consistent with your financial plan ! Periodically rebalance AA % back to target levels “automatic” market timing effect Takes money away from assets mostly highly valued And puts money into assets most under-valued

Professional level Asset Allocation (Kaufhold 2009) ---

Fully diversified portfolios (ST1 thru VLT3) with extensive allocations can then --- Produce risk similar to 100% US government bonds But with much higher return structure See, following statistical output ---

References --- Brinson, Hood, and Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal 42, no. 4 (July-August 1986): 35-47. Dreman, David, Contrarian Investment Strategies (1998). Gitman, Joehnk, Billingsley, “Personal Financial Planning, 12th ed. Graham, Benjamin, Security Analysis (1934). Kaufhold, Kevin, Advanced Portfolio Concepts, Theory and Practice (2009) Picerno, James, “How Many Stocks Should You Hold?”, Personal Finance, March 2002, 86-88.