1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 5 The Theory of Portfolio Allocation

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-2 Determinants of Portfolio Choice Theory of Portfolio Allocation: seeks to answer questions about portfolio choice and predicts how a saver distributes his or her savings across investments Determinants of Portfolio Choice are: Saver’s wealth to be allocated Expected return as compared to other investments The degree of risk of the asset compared to other assets The liquidity of the asset compared to other assets The cost of acquiring information about the asset

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-3 Figure 5.1 Portfolios of U.S. Households: 2006, 1970, 1950

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-4 Table 5.1 Determinants of Asset Allocation

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-5 Advantages of Diversification Diversification is the allocation of savings among many different assets. Holding multiple assets reduces risk.

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-6 Types of Risk Market risk is common risk across assets and can’t be eliminated. Systematic risk is unique to an asset and can be eliminated. Beta is a measure of systematic risk.

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-7 Figure 5.2 Reducing Risk Through Stock Portfolio Diversification

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-8 Explaining Portfolio Allocation Determinants of portfolio choice and diversification explain portfolio changes. Rise in wealth decreased checking balances. Assets in pension plans are rising due to tax deferral. Assets in mutual funds increased due to lower risk and information costs and greater liquidity.