1. Chapter 19
Asset Allocation

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 (cont’d)
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 (cont’d)
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 (cont’d)
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 (cont’d)
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9. How Diversification Reduces Risk (cont’d)
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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 (cont’d)
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 Among Stocks
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 (cont’d)
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14. Strategies for Diversifying Among Stocks (cont’d)
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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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 (cont’d)
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 (cont’d)
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 (cont’d)
Including stock options in the portfolio
Stock option: an option to purchase or sell stocks under specified conditions
Traded on exchanges
Call option: provides the right to purchase 100 shares of a specified stock at a specified price by a specified expiration date
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20. Asset Allocation Strategies (cont’d)
Exercise (strike) price: the price at which a stock option is exercised
Premium: the price that you pay when purchasing a stock option
Put option: provides the right to sell 100 shares of a specified stock at a specified price by a specified date
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21. Asset Allocation Strategies (cont’d)
The role of stock options in asset allocation
Very risky; should only pay a minimal role in asset allocation
Covered call strategy: selling call options on stock that you own
How asset allocation affects risk
To maintain a low risk, asset allocation should emphasize low risk investments
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22. Asset Allocation Strategies (cont’d)
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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23. Asset Allocation Strategies (cont’d)

24. Asset Allocation Strategies (cont’d)
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25. 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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26. Factors That Affect the Asset Allocation Decision (cont’d)
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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28. Financial Planning Online: Advice on Your Asset Allocation
Go to: investor/calcs/assetall/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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29. 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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30. Integrating Key Concepts
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