One example of an asset allocation strategy is life cycle investing An investment strategy in which asset allocation is based on the investor’s age or stage of life.-changing your asset allocation as you age. If the asset classes you choose are truly diverse, then the portfolio’s risk can be lower than the sum of the assets’ risks. Figure 12.11 "Proposed Asset Allocation" shows an asset allocation for an investor’s portfolio.Īsset allocation is based on the expected returns and relative risk of each asset class and how it will contribute to the return and risk of the portfolio as a whole. To maintain the desired allocation, the percentages are adjusted periodically as asset values change. Asset allocations are specified in terms of the percentage of the portfolio’s total value that will be invested in each asset class. The second diversification decision is asset allocation The strategy of achieving portfolio diversification by investing in different asset classes., deciding which asset classes, and therefore which risks and which markets, to invest in. That, in turn, will determine the portfolio’s level of return. It determines the portfolio’s overall exposure to risk, or the proportion of the portfolio that is invested in risky assets. The capital allocation decision is the first diversification decision. government to become insolvent-go bankrupt-and have to default on its debt within such a short time. Because it has such a short time to maturity, it won’t be much affected by interest rate changes, and it is probably impossible for the U.S. A “riskless” asset is the short-term (less than ninety-day) U.S.
is diversifying your capital between risky and riskless investments. In traditional portfolio theory, there are three levels or steps to diversifying: capital allocation, asset allocation, and security selection.Ĭapital allocation A strategy of diversifying a portfolio between risky and riskless assets. If you choose the investments well, if they are truly different from each other, the whole can actually be more valuable than the sum of its parts. To diversify well, you have to look at your collection of investments as a whole-as a portfolio-rather than as a gathering of separate investments.
among different kinds of firms, reducing company risks.among different kinds of investments, reducing asset class risk.among different sectors of the economy, reducing industry risks.between cyclical and countercyclical investments, reducing economic risk.To truly diversify, you need to invest in assets that are not vulnerable to one or more kinds of risk. Diversifying investments spreads risk by having more than one kind of investment and thus more than one kind of risk. Investing in different asset classes reduces your exposure to economic, asset class, and market risks.Ĭoncentrating investment concentrates risk. To lessen risk, you must expect less return, but another way to lessen risk is to diversify-to spread out your investments among a number of different asset classes. So, to increase return you must increase risk. The more risk assumed, the more the promised return. To invest is to assume risk, and you assume risk expecting to be compensated through return. And every investor wants to minimize risk, because it is costly. Compare and contrast active and passive portfolio strategies.Įvery investor wants to maximize return, the earnings or gains from giving up surplus cash.List the steps in creating a portfolio strategy, explaining the importance of each step.Explain the use of diversification in portfolio strategy.
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