1. Chapter 5 The Theory of Portfolio Allocation

2. Portfolio A portfolio is the set of financial assets that are owned by an individual. This chapter briefly discusses the determinants of the amount and types of assets that agents keep in their portfolio.

3. Determinants of Portfolio Choice 1.Wealth – Overall amount of financial assets 2.Expected Returns on Assets 3.Risk of Assets 4.Liquidity of Assets 5.Costs of Acquiring Information

4. Wealth Tautologically, the greater the wealth of an investor the larger is his portfolio in dollar terms. An increase in aggregate wealth increases aggregate demand for all types of assets. However, an increase in wealth might not have an equal effect on all assets.

5. Wealth Elasticity of Demand We calculate the wealth elasticity of an asset as If < 1, necessity asset (checking accounts) If > 1, luxury asset (stocks)

6. Expected Return on Assets The greater is the relative return on an asset, all else equal, the more of that asset that you would like to hold in your portfolio. Demand for an asset depends on its relative expected return. Agents care about real returns (i.e. total return – inflation rate).

7. Risk Exchange Fund Bills have circulated for 1 decade. The average yield for holding 1 year exchange fund bills is 5.61%. Average return on a portfolio matching the Hang Seng Index during this time is 22.65% Why would anyone buy exchange fund bills. The reason is that though the average was much higher for stocks, stocks were much more unpredictable. If you decide to hold a 1 year Exchange Fund Bill in your portfolio, you know the 1 year yield when you buy the bill. If you decide to hold a stock index fund, you do not know the 1 year return. Maximum y-o-y Hang Seng Return –12/92-12/93 117.64% Minimum y-o-y Hang Seng Return – 7/97 –7/98 - 46.59% Most Recent y-o-y Return – 8/00 –8/01 -32.40%

9. Risk Aversion Compare two assets. Both have the same expected return. One has a more volatile return than the other. If –You prefer the more predictable return, you are risk averse. –You are indifferent, you are risk neutral. –You prefer the more unpredictable return, you are risk loving. Most people are thought to be risk averse, which is why risky assets must offer higher returns.

10. Liquidity Liquidity is the cost, in terms of time and money of converting an asset into cash at any time. Since no one is ever certain about their future cash needs for transactions, people prefer liquid assets. Liquid assets are thought to be assets for which there are thick markets – I.e assets with many buyers or sellers.

11. Cost of Information To efficiently match an asset to your portfolio, you need information about that asset. The costlier that information is to obtain, the less of that asset you will prefer to hold in your portfolio. Most people’s stock portfolio’s are heavily loaded toward domestic equity. Presumably, it is easier to obtain information about domestic companies.