Asset Allocation and Investment Policy zAn investment strategy is based on four decisions y1. What asset classes to consider for investment y2. What normal or policy weights to assign to each eligible class y3. The allowable allocation ranges based on policy weights y4. What specific securities to purchase for the portfolio z85% to 95% of the overall investment return is due to the first two decisions, not the selection of individual investments

Asset Allocation Strategies zIntegrated asset allocation ycapital market conditions yinvestor’s objectives and constraints zStrategic asset allocation yconstant-mix zTactical asset allocation ymean reversion yinherently contrarian zInsured asset allocation yconstant proportion portfolio insurance

Integrated asset allocation Capital Market Conditions (C1) Prediction Procedure (C2) E(R), Risk, Correlations (C3) Investor’s Risk Tolerance (I3) Investor Risk Tolerance Function (I2) Investor Assets, Liab., Net Worth (I1) Optimizer (M1) Investor’s Asset Mix (M2) Realized Returns (M3)

Strategic asset allocation zUsed to develop a long-term policy allocation zExample: Portfolio will always rebalance to revert to a 60% Stock/30% Bond/10% Cash allocation zPractical issues: yFrequency of rebalancing yReevaluation of the policy allocation xex. Northeastern’s endowment

Tactical asset allocation zUsed to develop short-term strategies to exploit changes in market conditions zOften viewed as a contrarian strategy yAssume asset class performance is mean-reverting xif stocks have performed above average relative to bonds, underweight stocks and overweight bonds for next period yAssume stocks will generate above average returns xoverweight stocks! zPractical issues: yFrequency of rebalancing yConstraints on “swing component”

Insured asset allocation zUsed to develop short-term strategies to exploit changes in investor’s objectives and constraints zThis is a portfolio insurance strategy yAssumes investors become more risk-tolerant as wealth rises xif stocks have performed above average relative to bonds, overweight stocks for next period yAssumes investors become less risk-tolerant as wealth falls xIf stocks have performed poorly, underweight in next period zPractical issues: yFrequency of rebalancing yLiquidity

Which Allocation Strategy is Best? zDzDefine $ invested in stocks (S) ySyS = m(A - F) xwxwhere A = total asset value x F = floor value for assets x m = multiplier x B = $ invested in riskless bonds (=A-S) zTzThree Strategies (A=100): yByBuy and Hold(m=1, F=40) yCyConstant Mix(m=.6, F=0) yPyPortfolio Insurance(m=2, F=70)