Asset Allocation and Investment Policy

An investment strategy is based on four decisions 1. What asset classes to consider for investment 2. What normal or policy weights to assign to each eligible

class 3. The allowable allocation ranges based on policy weights 4. What specific securities to purchase for the portfolio

85% to 95% of the overall investment return is due to the first two decisions, not the selection of individual investments

Asset Allocation Strategies

Integrated asset allocation capital market conditions investor’s objectives and constraints

Strategic asset allocation constant-mix

Tactical asset allocation mean reversion inherently contrarian

Insured asset allocation constant proportion portfolio insurance

Integrated asset allocation

Capital Market Conditions (C1)

Prediction Procedure (C2)

E(R), Risk, Correlations (C3)

Investor’s Risk Tolerance (I3)

Investor Risk Tolerance Function (I2)

Investor Assets, Liab., Net Worth (I1)

Optimizer (M1)

Investor’s Asset Mix (M2)

Realized Returns (M3)

Strategic asset allocation

Used to develop a long-term policy allocation

Example: Portfolio will always rebalance to revert to a 60% Stock/30% Bond/10% Cash allocation

Practical issues: Frequency of rebalancing Reevaluation of the policy allocation

ex. Northeastern’s endowment

Tactical asset allocation

Used to develop short-term strategies to exploit changes in market conditions

Often viewed as a contrarian strategy Assume asset class performance is mean-reverting

if stocks have performed above average relative to bonds, underweight stocks and overweight bonds for next period

Assume stocks will generate above average returns overweight stocks!

Practical issues: Frequency of rebalancing Constraints on “swing component”

Insured asset allocation

Used to develop short-term strategies to exploit changes in investor’s objectives and constraints

This is a portfolio insurance strategy Assumes investors become more risk-tolerant as wealth

rises if stocks have performed above average relative to bonds,

overweight stocks for next period Assumes investors become less risk-tolerant as wealth falls

If stocks have performed poorly, underweight in next period

Practical issues: Frequency of rebalancing Liquidity

Which Allocation Strategy is Best?

Define $ invested in stocks (S) S = m(A - F)

where A = total asset value F = floor value for assets m = multiplier B = $ invested in riskless bonds (=A-S)

Three Strategies (A=100): Buy and Hold (m=1, F=40) Constant Mix (m=.6, F=0) Portfolio Insurance (m=2, F=70)