1. Chapter 11 – Diversification & Allocation Concepts
Winter 2011 Fin / Invest / Business Law Cluster Kevin C. Kaufhold 1

2. Diversification noted briefly, text, at 381 ---
“Don’t put all your eggs in one basket”
Is process of choosing assets with dissimilar risk-return characteristics
Can reduce or eliminate firm-specific “unique” risk
Leaves only systematic risk felt by an entire asset market
Maintains return, but minimizes risk to market-level volatility
May be the closest thing there is to a “free lunch” 2

3. How many assets are need to be diversified?
Some recent studies suggest 50 – 75 securities (Picerno, 2002)
Older studies / commentary suggested as few as 10 to 30 securities (Graham, 1934; Dreman, 1998)
Following graph shows power of diversification (Kaufhold, 2009) 3

4. 4

5. Adding international assets can reduce risk to WORLD-WIDE systematic levels (Kaufhold, 2009)5

6. Firm-level risk can be eliminated by diversification ---
But what about market-level risk?
Cannot eliminate systematic risk
But can at least manage it through a process known as --- 6

7. Asset Allocation, text, a 381 – 386
AA is a financial plan for dividing or allocating money between different asset classes
Emphasis is on preserving capital (e.g. Thinking Patterns paper)
AA is not a plan to buy or sell individual assets
AA IS a plan to allocate % of portfolio across asset classes
Why do we allocate????? 7

8. Most of a portfolio’s risk-return structure comes from allocation across asset classes
And NOT individual asset selection
Up to 90% of return variability (i.e. risk) of a portfolio comes from the allocation decision (Brinson, Hood, and Beebower, 1986)
Only 10% comes from individual assets 8

9. Allocate between Stocks, Bonds, Cash
And possibly, RE and other alternative assets
But, what percentages? text, at 381 –
risk tolerances
holding period
net worth
age
family factors
Many other social and economic influences

10. “Average” AA, text, at 382 ---
Stocks, stock funds %
Bonds, bond funds %
Cash, ST near-cash %
Total %
This is fairly aggressive, but with lots of ST cash needs

11. A more “balanced” AA, with some ST cash needs ---
Stocks %
Bonds %
Cash %
“Balanced” AA, with few ST cash needs (rainy day fund)
Stocks % %
Bonds % %
Cash % %

12. As your exposure to equities increase
Volatility (i.e. risk) increases
But “expected” return also increases
Higher risk, higher return
Maintain AA percentages
To preserve capital consistent with your financial plan !
Periodically rebalance AA % back to target levels
“automatic” market timing effect
Takes money away from assets mostly highly valued
And puts money into assets most under-valued

13. Professional level Asset Allocation (Kaufhold 2009) ---

14. Fully diversified portfolios (ST1 thru VLT3) with extensive allocations can then ---
Produce risk similar to 100% US government bonds
But with much higher return structure
See, following statistical output ---

16. References ---
Brinson, Hood, and Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal 42, no. 4 (July-August 1986):
Dreman, David, Contrarian Investment Strategies (1998).
Gitman, Joehnk, Billingsley, “Personal Financial Planning, 12th ed.
Graham, Benjamin, Security Analysis (1934).
Kaufhold, Kevin, Advanced Portfolio Concepts, Theory and Practice (2009)
Picerno, James, “How Many Stocks Should You Hold?”, Personal Finance, March 2002,