Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter 18 Asset Allocation.

Copyright ©2004 Pearson Education, Inc. All rights reserved.

Chapter 18

Asset Allocation

Copyright ©2004 Pearson Education, Inc. All rights reserved. 18-2

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


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



– 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



• 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



Exhibit 18.1: Example of Portfolio Diversification Effects



• 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



Exhibit 18.2: Impact of a Stock’s Volatility on Portfolio Diversification Effects



Exhibit 18.3: Impact of Stock Correlations on Portfolio Diversification Effects


Financial Planning Online: Correlations among Stock Returns

• Go to: http://finance.yahoo.com/?u

• 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.”

http://finance.yahoo.com/?u


Financial Planning Online: Correlations among Stock Returns

• Next, enter the symbol for another stock in the box just below the chart where is says “Compare.”


Strategies for Diversifying

• 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


Strategies for Diversifying Among Stocks

Exhibit 18.4: Benefits of Portfolio Diversification


Strategies for Diversifying Among Stocks• 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


Strategies for Diversifying Among Stocks

Exhibit 18.5: Benefits from International Stock Diversification


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



– 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



– Role of REITs in asset allocation• REITs could perform well when stocks or bonds

are performing poorly



• Stock option: an option to purchase or sell stocks under specified conditions– Traded on exchanges

• How asset allocation affects risk– To maintain a low risk, asset allocation

should emphasize low risk investments



• Benefits of asset allocation– Investors who diversify experience better

performance

• An affordable way to conduct asset allocation– Invest in different types of mutual funds






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


Factors That Affect the Asset Allocation Decision• 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


Factors That Affect the Asset Allocation Decision

Exhibit 18.8: Asset Allocation over Time


Financial Planning Online: Advice on Your Asset Allocation

• Go to: http://moneycentral.msn.com/investor/calcs/assettall/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.

http://moneycentral.msn.com/investor/calcs/assettall/main.asp




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?


Integrating Key Concepts

Integrating Key Concepts

• Part 1: Financial Planning Tools

• Part 2: Liquidity Management

• Part 3: Financing

• Part 4: Protecting Your Assets and Income

• Part 5: Investing– In Chapter 13 we learned about investment fundamentals

– In Chapter 14 we learned about stock analysis and valuation

– In Chapter 15 we learned about investing in stocks

– In Chapter 16 we learned about investing in bonds

– In Chapter 17 we learned about investing in mutual funds

– In Chapter 18 we learned about cover asset allocation

• Part 6: Retirement and Estate Planning


Call Options

• Call option: an option on a specified stock that provides the right to purchase 100 shares at a specified price by a specified expiration date– Exercise (strike) price: the price specified

for exercising a stock option

– Premium: the price that you pay when purchasing a stock option


Including Stock Options in Your Asset Allocation

• Selling a call option — seller obligated to sell the shares of the specified stock to the buyer for the exercise price if and when the buyer exercises the option

• Gain or loss from trading call options– Determined by the amount received when

the stock is sold, the amount paid for the stock and the amount paid for the premium


Put Options

• Put option: an option on a specified stock that provides the right to sell 100 shares at a specified price by a specified expiration date

• Selling a put option – Seller obligated to buy the shares of the

specified stock from the buyer of the put option for the exercise price if and when the buyer exercises the option


Put Options

• Gain or loss from trading put option

– Net gain or loss can be determined by considering the amount received when you sell the stock, the amount you paid for the stock and the amount you paid for the premium

Quotations of Stock Options

• Column 1 — name of stock

• Column 2 — exercise price

• Column 3 — expiration date

• Column 4 — volume of contracts traded

• Column 5 — latest quoted premium of call options

• Column 6 — volume of put options

• Column 7 — latest quoted premium of put options



Exhibit 18.A1: An Example of Stock Option QuotationsCopyright © 2001 Dow Jones & Company, Inc. All Rights Reserved.



• In the money: a stock option that can be exercised profitably

• Out of the money: a stock options that cannot be exercised profitably

• At the money: an option on a stock whose prevailing price is equal to the option’s exercise price


Factors That Affect the Option Premium

• Stock price relative to exercise price

• Option’s time to expiration– A longer maturity results in a higher

premium

• Stock’s volatility– Highly volatile stocks result in higher

premiums


The Role of Stock Options in Asset Allocation• Very risky; should play only minimal role

in asset allocation

• Buying put options on stocks you own limits your risk

• Buying call options on stocks you own reduces your risk– Covered call strategy: selling call options

on stock that you own

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Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter 18 Asset Allocation.

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