1. Chapter 18 Asset Allocation
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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
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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
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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
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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
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6. How Diversification Reduces Risk
Exhibit 18.1: Example of Portfolio Diversification Effects
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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
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8. How Diversification Reduces Risk
Exhibit 18.2: Impact of a Stock’s Volatility on Portfolio Diversification Effects
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9. How Diversification Reduces Risk
Exhibit 18.3: Impact of Stock Correlations on Portfolio Diversification Effects
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10. 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.”
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11. 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.”
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12. 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
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13. Strategies for Diversifying Among Stocks
Exhibit 18.4: Benefits of Portfolio Diversification
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14. 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
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15. Strategies for Diversifying Among Stocks
Exhibit 18.5: Benefits from International Stock Diversification
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16. 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
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17. 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
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18. Asset Allocation Strategies
Role of REITs in asset allocation
REITs could perform well when stocks or bonds are performing poorly
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19. 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
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20. 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
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21. Asset Allocation Strategies
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22. Asset Allocation Strategies
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23. 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
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24. 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
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25. Factors That Affect the Asset Allocation Decision
Exhibit 18.8: Asset Allocation over Time
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26. Financial Planning Online: Advice on Your Asset Allocation
Go to: 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.
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27. 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?
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28. Integrating Key Concepts
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29. 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

30. 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
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31. 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
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32. 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
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33. 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
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34. 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

35. Quotations of Stock Options
Exhibit 18.A1: An Example of Stock Option Quotations
Copyright © 2001 Dow Jones & Company, Inc. All Rights Reserved.
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36. 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
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37. 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
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38. 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
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