APPENDIX 20A ASSET ALLOCATION

OUTLINE Strategic Asset Allocation Tactical Asset Allocation Drifting Asset Allocation Balanced Asset Allocation Dynamic (Insured) Asset Allocation

STRATEGIC ASSET ALLOCATION INFORMAL APPROACH 1. SUBJECTIVELY ASSESS RISK TOLERANCE AS ‘LOW’, ‘MEDIUM’, OR ‘HIGH’. 2. DEFINE THE INVESTMENT HORIZON AS ‘SHORT’, ‘INTERMEDIATE’, OR ‘LONG’. 3. ESTABLISH THE OPTIMAL STRATEGIC ASSET ALLOCATION USING SOME ‘RULE OF THUMB’. FORMAL APPROACH 1. DEVELOP QUANTITATIVE FORECASTS OF E(R),  (R), AND  S, B 2. DEFINE THE EFFICIENT FRONTIER 3. SPECIFY UTILITY INDIFFERENCE 4. CHOOSE THE OPTIMAL PORTFOLIO

STRATEGIC ASSET ALLOCATION A: QUANTITATIVE FORECASTSB: EFFICIENT E(R P ) FRONTIER EXPECTED STANDARD RETURN DEVIATION STOCKS 20.2% 18.0% STOCKS BONDS 13.0% 8.2% CORRELATION BONDS  P C: UTILITY INDIFFFERENCE D: OPTIMAL PORTFOLIO (STRATEGIC CURVES ASSET ALLOCATION) E(R P )E(R P ) I 3 I 2 I 1 X Y   P  P

DRIFTING ASSET ALLOCATION BUY AND HOLD POLICY. NO REBALANCING PAYOFF STOCK MARKET LEVEL PORTFOLIO VALUE … LINEARLY RELATED TO THE STOCK MARKET PORTFOLIO VALUE CAN’T FALL BELOW THE INITIAL INVESTMENT IN BONDS

BALANCED ASSET ALLOCATION

CONSTANT MIX POLICY

DYNAMIC (OR INSURED) ASSET ALLOCATION SHIFTING THE ASSET MIX MECHANISTICALLY IN RESPONSE TO CHANGING MARKET CONDITIONS A CPPI POLICY TAKES THE FOLLOWING FORM: INVESTMENT= mPORTFOLIO - FLOOR IN STOCKSVALUE m > 1 50=2 [ ]

PORTFOLIO COMPOSITION AND PAYOFFS FOR THE THREE POLICIES MARKET LEVEL IS 100 PORTFOLIO STOCKS BONDS TOTAL BUY AND HOLD POLICY 50,000 50, ,000 CONSTANT MIX POLICY 50,000 50, ,000 CONSTANT PROPORTION PORTFOLIO INSURANCE POLICY 50,000 50, ,000 MARKET LEVEL FALLS TO 80 PORTFOLIOPORTFOLIO (BEFORE RABALANCING) (AFTER REBALANCING) STOCKS BONDS TOTAL STOCKS BONDS TOTAL BUY AND 40,000 50,000 90,000 40,000 50,00090,000 POLICY CONSTANT 40,000 50,000 90,000 45,000 45,000 90,000 MIX POLICY CONSTANT 40,000 50,000 90,000 30,000 60,00090,000 PROPORTION PORTFOLIO INSURANCE POLICY

MARKET LEVEL RISES TO 100 PORTFOLIOPORTFOLIO (BEFORE RABALANCING) (AFTER REBALANCING) STOCKS BONDS TOTAL STOCKS BONDS TOTAL BUY AND 50,000 50, ,000 50,000 50, ,000 POLICY CONSTANT 56,250 45, ,250 50,625 50, ,000 MIX POLICY CONSTANT 36,000 60,000 96,000 42,000 54,00096,000 PROPORTION PORTFOLIO INSURANCE POLICY

GRAPHICAL PICTURE PAYOFF CPPI POLICY BUY AND HOLD POLICY CONSTANT MIX POLICY STOCK MARKET LEVEL

PERFORMANCE FEATURES DRIFTING ASSET ALLOCATION POLICY STRAIGHT LINE PAYOFF DOWNSIDE PROTECTION MIDDLING PERFORMANCE BALANCED ASSET ALLOCATION POLICY CONCAVE PAYOFF SOME DOWNSIDE PROTECTION DOES WELL IN FLAT, BUT FLUCTUATING, MARKETS CPPI POLICY CONVEX PAYOFF GOOD DOWNSIDE PROTECTION & PERFORMS WELL IN UP MARKET DOES POORLY IN FLAT, BUT FLUCTUATING, MARKETS

RISK TOLERANCE IN RESPONSE TO RECENT RETURNS RISK TOLERANCED C B A RECENT RETURNS 100S : 50B : 50 S : 70B : 50 A : TACTICALS : 48B : 72(40 : 60) B : BALANCED S : 60B : 60(50 : 50) C : DRIFTINGS : 70B : 50 D : INSURED S : 80B : 40 A : RISK TOLERANCE UNAFFECTED BY WEALTH CHANGES IF THE MARKET … PROSPECTIVE RETURNS MOVE TO A MORE DEF. POSTURE B : MILDLY SENSITIVE TO RECENT CHANGES IN WEALTH C : MORE SENSITIVE TO RECENT CHANGES IN WEALTH D : HIGHLY SENSITIVE TO RECENT CHANGES IN WEALTH

RETURN AND COMFORT IN EFFECT, WE HAVE NATURAL CANDIDATES FOR PORTFOLIO INSURANCE, FOR A DRIFTING ASSET MIX, FOR SIMPLE REBALANCING TO A STATIC MIX, & FOR TACTICAL ASSET ALLOCATION. JUST AS PORTFOLIO INSURANCE IS NOT RIGHT FOR EVERYONE, THE SAME CAN BE SAID TACTICAL ASSET ALLOCATION. THIS HOLDS FOR THE SIMPLE REASON THAT AN IMPOVEMENT IN LONG-TERM RETURNS DOES NOT MEAN AN IMPROV’T IN THE “UTILITY” FOR ALL INVESTORS; UTILITY REFLECTS THE NATURAL HUMAN DESIRE FOR BOTH RETURN AND COMFORT. THE RETURNS FOR THE PATIENT, LONG-TERM INVESTOR, USING TACTICAL ASSET ALLOCATION, EXCEED THOSE OF THE REBALANCING INVESTOR, WHICH EXCEED THOSE OF THE DRIFTING MIX INVESTOR, WHICH EXCEED THOSE OF THE INSURANCE-ORIENTED INVESTOR. THE INVESTOR WITH THE PATIENCE & RISK-TOLERANCE TO FOLLOW A LESS-CONVENTIONAL & LESS- COMFERTABLE APPROACH EARNS REWARDS AT THE EXPENSE OF THE INVESTOR WITH THE SHORTER INVESTMENT HORIZON & AN INTOLERANCE FOR THE LOSSES THAT ACCOMPANY MARKET DELCINES. … WHEN WEALTH IS DECLINING, MOST INVESTORS SEEK THE SOLACE OF LOWER RISK, HENCE LOWER EXPOSURE TO RISKY MKTS … FEW INVESTORS RUSHED TO BUY STOCKS AFTER THE DISASTROWS BEAR MKT OR AFTER 1987 CRASH