Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter 18 Asset Allocation

Copyright ©2004 Pearson Education, Inc. All rights reserved.18-2 Chapter Objectives Explain how diversification among assets can reduce risk Describe strategies that can be used to diversify among stocks Explain asset allocation strategies Identify factors that affect your asset allocation decisions

Copyright ©2004 Pearson Education, Inc. All rights reserved.18-3 How Diversification Reduces Risk Benefits of portfolio diversification –Asset allocation: the process of allocating money across financial assets with the objective of achieving a desired return while maintaining risk of a tolerable level –Building a portfolio Portfolio: a set of multiple investments in different assets

Copyright ©2004 Pearson Education, Inc. All rights reserved.18-4 How Diversification Reduces Risk –Focus on Ethics: The risk of insider trading Insider information: information known by insiders (such as managers) of a firm, but not known by investors Investors can legally only use information that is publicly available Securities and Exchange Commission prosecutes violators

Copyright ©2004 Pearson Education, Inc. All rights reserved.18-5 How Diversification Reduces Risk Determining portfolio benefits –Compare return on the investments within the portfolio to the overall portfolio –Diversification reduces the exposure of your investments to the adverse effects of any individual investment

Copyright ©2004 Pearson Education, Inc. All rights reserved.18-6 How Diversification Reduces Risk Exhibit 18.1: Example of Portfolio Diversification Effects

Copyright ©2004 Pearson Education, Inc. All rights reserved.18-7 How Diversification Reduces Risk Factors that influence diversification benefits –Volatility of each individual stock –Impact of correlations among stocks Highly correlated stocks limit diversification Consider stocks that are not influenced by the same conditions

Copyright ©2004 Pearson Education, Inc. All rights reserved.18-8 How Diversification Reduces Risk Exhibit 18.2: Impact of a Stock’s Volatility on Portfolio Diversification Effects

Copyright ©2004 Pearson Education, Inc. All rights reserved.18-9 How Diversification Reduces Risk Exhibit 18.3: Impact of Stock Correlations on Portfolio Diversification Effects

Copyright ©2004 Pearson Education, Inc. All rights reserved Financial Planning Online: Correlations among Stock Returns Go to: This Web site provides a graph that shows the returns on two stocks so that you can determine their degree of correlation. To perform your own comparison, insert a stock symbol, and then click on “Charts.”

Copyright ©2004 Pearson Education, Inc. All rights reserved Financial Planning Online: Correlations among Stock Returns Next, enter the symbol for another stock in the box just below the chart where is says “Compare.”

Copyright ©2004 Pearson Education, Inc. All rights reserved Strategies for Diversifying Diversification of stocks across industries –Less risky than a portfolio of stocks all from the same industry –Even such a portfolio is still susceptible to general economic conditions

Copyright ©2004 Pearson Education, Inc. All rights reserved Strategies for Diversifying Among Stocks Exhibit 18.4: Benefits of Portfolio Diversification

Copyright ©2004 Pearson Education, Inc. All rights reserved Strategies for Diversifying Among Stocks Diversification of stocks across countries –Economic conditions tend to vary among countries –Foreign stocks typically more volatile than U.S. stocks so it is best to diversify among stocks within each foreign country –Many advisors recommend an 80/20 split between U.S. and foreign stocks

Copyright ©2004 Pearson Education, Inc. All rights reserved Strategies for Diversifying Among Stocks Exhibit 18.5: Benefits from International Stock Diversification

Copyright ©2004 Pearson Education, Inc. All rights reserved Asset Allocation Strategies Including bonds in the portfolio –Bond and stock returns are not highly correlated –Investing in more bonds lowers market risk but increases interest rate risk Including real estate investments in the portfolio –Real estate investment trusts (REITs): trusts that pool investments from individuals and use the proceeds to invest in real estate

Copyright ©2004 Pearson Education, Inc. All rights reserved Asset Allocation Strategies –Similar to closed-end mutual funds –Managed by real estate professional –Types of REITs Equity REITs: REITs that invest money directly in properties Mortgage REITs: REITs that invest in mortgage loans that help to finance the development of properties

Copyright ©2004 Pearson Education, Inc. All rights reserved Asset Allocation Strategies –Role of REITs in asset allocation REITs could perform well when stocks or bonds are performing poorly

Copyright ©2004 Pearson Education, Inc. All rights reserved Asset Allocation Strategies Stock option: an option to purchase or sell stocks under specified conditions –Traded on exchanges How asset allocation affects risk –To maintain a low risk, asset allocation should emphasize low risk investments

Copyright ©2004 Pearson Education, Inc. All rights reserved Asset Allocation Strategies Benefits of asset allocation –Investors who diversify experience better performance An affordable way to conduct asset allocation –Invest in different types of mutual funds

Copyright ©2004 Pearson Education, Inc. All rights reserved Asset Allocation Strategies

Copyright ©2004 Pearson Education, Inc. All rights reserved Asset Allocation Strategies

Copyright ©2004 Pearson Education, Inc. All rights reserved Factors That Affect the Asset Allocation Decision Your stage in life –Younger investors need safer, more liquid securities –Investors not needing liquidity might consider investing in securities with high growth potential –Investors nearing retirement may choose investments that will generate income

Copyright ©2004 Pearson Education, Inc. All rights reserved Factors That Affect the Asset Allocation Decision Your degree of risk tolerance Your expectations about economic conditions –If you expect a strong stock market, invest in stocks –If you expect a weak stock market, invest in bonds –If you expect lower interest rates, invest in long-term bonds –If you expect favorable real estate conditions, invest in REITs

Copyright ©2004 Pearson Education, Inc. All rights reserved Factors That Affect the Asset Allocation Decision Exhibit 18.8: Asset Allocation over Time

Copyright ©2004 Pearson Education, Inc. All rights reserved Financial Planning Online: Advice on Your Asset Allocation Go to: assettall/main.asp assettall/main.asp This Web site provides a personal recommended asset allocation considering your income, your stage in life, and other characteristics once you input some basic information.

Copyright ©2004 Pearson Education, Inc. All rights reserved How Asset Allocation Fits within Your Financial Plan Key decision concerning asset allocation for your financial plan are: –Is your present asset allocation of investments appropriate? –How will you apply asset allocation in the future?

Copyright ©2004 Pearson Education, Inc. All rights reserved Integrating Key Concepts

Part 1: Financial Planning Tools Part 2: Liquidity Management Part 3: Financing Part 4: Protecting Your Assets and Income Part 5: Investing –In Chapter 13 we learned about investment fundamentals –In Chapter 14 we learned about stock analysis and valuation –In Chapter 15 we learned about investing in stocks –In Chapter 16 we learned about investing in bonds –In Chapter 17 we learned about investing in mutual funds –In Chapter 18 we learned about cover asset allocation Part 6: Retirement and Estate Planning

Copyright ©2004 Pearson Education, Inc. All rights reserved Call Options Call option: an option on a specified stock that provides the right to purchase 100 shares at a specified price by a specified expiration date –Exercise (strike) price: the price specified for exercising a stock option –Premium: the price that you pay when purchasing a stock option

Copyright ©2004 Pearson Education, Inc. All rights reserved Including Stock Options in Your Asset Allocation Selling a call option — seller obligated to sell the shares of the specified stock to the buyer for the exercise price if and when the buyer exercises the option Gain or loss from trading call options –Determined by the amount received when the stock is sold, the amount paid for the stock and the amount paid for the premium

Copyright ©2004 Pearson Education, Inc. All rights reserved Put Options Put option: an option on a specified stock that provides the right to sell 100 shares at a specified price by a specified expiration date Selling a put option –Seller obligated to buy the shares of the specified stock from the buyer of the put option for the exercise price if and when the buyer exercises the option

Copyright ©2004 Pearson Education, Inc. All rights reserved Put Options Gain or loss from trading put option –Net gain or loss can be determined by considering the amount received when you sell the stock, the amount you paid for the stock and the amount you paid for the premium

Quotations of Stock Options Column 1 — name of stock Column 2 — exercise price Column 3 — expiration date Column 4 — volume of contracts traded Column 5 — latest quoted premium of call options Column 6 — volume of put options Column 7 — latest quoted premium of put options

Copyright ©2004 Pearson Education, Inc. All rights reserved Quotations of Stock Options Exhibit 18.A1: An Example of Stock Option Quotations Copyright © 2001 Dow Jones & Company, Inc. All Rights Reserved.

Copyright ©2004 Pearson Education, Inc. All rights reserved Quotations of Stock Options In the money: a stock option that can be exercised profitably Out of the money: a stock options that cannot be exercised profitably At the money: an option on a stock whose prevailing price is equal to the option’s exercise price

Copyright ©2004 Pearson Education, Inc. All rights reserved Factors That Affect the Option Premium Stock price relative to exercise price Option’s time to expiration –A longer maturity results in a higher premium Stock’s volatility –Highly volatile stocks result in higher premiums

Copyright ©2004 Pearson Education, Inc. All rights reserved The Role of Stock Options in Asset Allocation Very risky; should play only minimal role in asset allocation Buying put options on stocks you own limits your risk Buying call options on stocks you own reduces your risk –Covered call strategy: selling call options on stock that you own