The Concept of Asset Allocation

Posted: August 27th, 2021

Portfolio Management

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Portfolio Management

Part 1: Asset Allocation

The Concept of Asset Allocation

Businesses and individuals should have investment strategies that suit their goals and objectives, as it balances their reward and risk. Asset allocation is a type of strategy investors utilize in enabling them to get their expected returns from an investment. It is achieved by altering asset distribution, leading to balancing an investor’s risk and reward (Goldstein, Jiang & Ng, 2017). Assets consist of three classes that investors can hold. These are fixed income, equities, plus cash and its equivalents, which all have varying risk levels and returns. The different rewards and risks involved make the investment options perform differently during varying periods (Goldstein et al., 2017). Asset allocation leads to the distribution of assets classes and wealth in different regions or countries for various investment purposes. Thus, asset classes comprise financial securities that mostly have similar risks, attributes, characteristics, and returns.

Factors Influencing Asset Allocation

Investors have several motivations that influence their investment decisions, determining where and how they invest their investments. Investors consider their personal or business objectives when deciding on the type of investment to choose, mostly influenced by their aspirations or vision. Risk tolerance is another factor influencing an investor’s investment strategy, and it is determined by how they are risk-averse or takers. Besides, the time horizon is another essential factor to consider when choosing the investment strategy. The reason is that different investors have varying durations that they desire their investments to hold. Therefore, these factors are crucial in determining the strategy to utilize when deciding when and where they will invest.

Asset AllocationImportance

Investors should be aware of the essence of asset allocation. This is because it is critical when it comes to the utilization of various asset allocation methods essential for getting and analyzing investment information. Equally, understanding the concept of asset allocation quips investors with techniques to analyze different sets of the portfolio before the decision-making process about their investment objectives. The techniques are also used in assessing savings patterns, habits, and aims to evaluate the investors’ savings purpose (Lo et al., 2019). Likewise, investors can make savings towards their short, medium, and long term financial goals besides tracking the same using assets allocation techniques. For example, when purchasing a new car and house or long-term purposes like early retirement, the concept becomes critical. Hence, when an investment risk tolerance is low, investors should not be exposed to equities or less exposed to them since equities fluctuate. Therefore, investors should implement diverse investment strategies as market conditions play an essential role in risk management, volatility, and returns in an investment portfolio.

Strategies of Asset Allocation

When evaluating assets allocation, it is always a complicated avenue assessing and digging inside each asset class. The reason is that there is a need to examine the chain of sub-categories (Fisher et al., 2020; Goldstein, Jiang & Ng, 2017). Equally, when allocating assets, there are two types of stock: small and large-cap stocks. The small-cap stocks are considered growing stocks yet highly volatile, while large caps are mature value stocks with the least potential for growth although highly stable compared to small caps (Fisher, Pettenuzzo & Carvalho, 2020). Investors also evaluate the target countries to have their investment interests. Different countries offer diverse investment options with unique returns. For instance, investment in the U.S securities is governed by various government agencies such as the Securities and Exchanges Commission (SEC) that enhance safe investment markets, accountability, and transparency (Fisher, Pettenuzzo & Carvalho, 2020). Besides, investors consider the U.S securities since fewer insider dealings characterize them. Besides, it has the least market manipulation than other countries, hence, less susceptible to insider trading and market manipulation.

Likewise, investors evaluate trading in other financial instruments such as treasury bills, corporate, and government bonds. This offers a more stable return and is less risky than investments in portfolios, such as shares in the stock exchange markets. Besides, corporate and government bonds offer different ratings and returns that safeguard the investors’ funds through diversification (Goldstein, Jiang & Ng, 2017). More so, according to Fisher, Pettenuzzo & Carvalho (2020), government bonds also comprise bonds on third world country governments with high coupon rates but high default risks or treasury bills with minimal default chances. Therefore, investors should consider factors like frequency of purchasing and selling stocks and how active the portfolio allocation is when making investment decisions. As such, investors who purchase financial instruments and hold them often consider their allocation as static. When the security drops in price, the investor rebalances the investment portfolio by purchasing more financial instruments (Fisher, Pettenuzzo & Carvalho, 2020). On the other hand, when the financial instrument increases in value, the investors make withdrawals as profits to stabilize the overall allocation. Therefore, the investors should dynamically vary their asset allocation in their investments according to variations in market conditions to maximize their returns from laws of demand and supply.

The Two Fund Theorem

The theory states that investors invest in a portfolio containing all the available financial assets in the market, such as stocks and risk-free assets like T-bills. Furthermore, it holds that each asset held by an investor is in proportion to the individual market value concerning the total assets market value (Choi et al., 2017). Hence, investors prefer to diversify their risk by investing in more than one efficient portfolio, such as a risk-free and risky asset.  Risk-free assets offer fixed returns to investors, and their future can be calculated with certainty based on its net present value (NPV), for instance, T-bills (Goldstein, Jiang & Ng, 2017). Contrarily, risky assets offer high returns to investors but have uncertain market value as the high the risk, and the increased the returns.

Risk-Free Asset

It is a financial instrument with certain returns and no possibility of declining value or becoming insignificant in the future. Low return rates characterize these assets as relatively safe, and investors are not awarded a premium for taking risks in their investments (Choi et al., 2017). Furthermore, risk-free assets are only affected by inflation, leading to a decrease in money purchasing power as they are guaranteed against nominal losses. Thus, the financial assets are exposed to reinvestment risks in the future.

Optimal Capital Allocation Line (CAL) With a Risk-Free Asset and Two Risky Assets

CAL requires numerous steps and processes to model an investment portfolio as the ideal portfolio for an investor should consist of risky and risk-free assets to diversify investment risks (Vukovic & Prosin, 2018). The portfolio’s optimum risky asset is given when the CAL line is tangent to the efficient frontier curve (EFC). Additionally, the CAL slope indicates the financial asset that offers the highest returns with an additional risk unit giving the optimal risks to the rewards ratio (Fisher, Pettenuzzo & Carvalho, 2020). Hence, investors employ EFC and Cal to determine and achieve various risks to get the optimal portfolio combinations as their preference. Besides, the curve helps investors select funds to invest in risky and risk-free assets to hedge their risks, maximizing returns, for instance, between shares and T-bills.

Developing Portfolio in the Capital Allocation Line (CAL)

The most effective way of regulating the portfolio’s risk is regulating investments on risk-free assets as the overall portfolio include risk-free and risky financial assets (Vukovic & Prosin, 2018). Consequently, this combination is represented graphically on the y and x-axis, with the y-axis denoting the portfolio’s expected returns, and x-axis risk indicated by the portfolio’s standard deviation.

Combination withthe Risk-Free Rate

The CAL line provides the possibility of deleveraging and leveraging that imply using debt financing in assets allocation (Vukovic & Prosin, 2018). Therefore, incomplete leverage arises when the borrowing costs are greater than the cost of purchasing risk-free assets.

The Slope of CAL

The CAL line’s slope denotes the incremental returns per incremental risk of a financial asset (Vukovic & Prosin, 2018).  The slope is different when the portfolio’s risk-free rate is financed on debts as it will marginally flatten.

Part 2: Portfolio Selection

Investors should select the ideal portfolio in an investment with the highest Sharpe ratio of more than 2.11 after factoring 1.25% of the risk-free rate (Vukovic & Prosin, 2018). The highest Sharpe ratio indicates the best returns since it shows there is low or no relationship on the portfolio’s financial assets under consideration. Therefore, the efficient portfolio curve below indicates that the shares have low risk and volatility compared to other portfolio investments but equally high expected returns.

Figure 1:Efficient Frontier

Part 3: Measuring the Portfolio Performance

Investors should employ the three techniques of measuring and quantifying portfolio risk and returns when making investment decisions (Vukovic & Prosin, 2018). However, there is no single perfect technique for measuring portfolio performance. A combination of these tools is used to calculate the portfolio risk and returns. The main three financial metrics are the Sharpe Ratio, Jensen measure, and Treynor Measure (Nwogugu, 2018). Equally, the techniques are implemented by expressing performance risk and returns as a single value (Vukovic & Prosin, 2018). Hence, the three measures are essential in measuring portfolio risks despite their unique individual characteristics.

Treynor Performance Measurement Tool

It was established by Jack Treynor (Goldstein, Jiang & Ng, 2017). It is also referred to as a rewards-to-volatility ratio. Its primary aim is to offer investors a compound measurement method in the portfolio’s performance and risk(Goldstein, Jiang & Ng, 2017). The fundamental objective is to provide an all-inclusive performance measurement for financial investors regardless of individual preferences and risk appetite (Nwogugu, 2018). Therefore, the tool recommends two portfolio risk components that risk individual security volatility and stock market variations. Furthermore, the performance tool adopts a security market line (SML) that indicates the correlation of market returns and portfolio yields with the slope indicating comparative portfolio and market volatility denoted by beta (Vukovic & Prosin, 2018). The measure is expressed as below;

Therefore, as demonstrated above, the risk premium is the difference between the portfolio returns and risk-free return, and beta is the risk.

Sharpe Ratio

William Sharpe initially introduced it in 1966. The ratio can be expressed as the Treynor measure. Still, the only difference is that the Sharpe ratio portfolio risk is denoted by the standard deviation instead of beta in Treynor measure (Pettenuzzo & Carvalho, 2020). At the same time, the ratio is related to the capital assets pricing model (CAPM) as it adopts the capital market line (CML) in the portfolio’s overall risk (Nwogugu, 2018). The ratio is given as;

Jensen Measure

The measure was developed by Michael Jensen and commonly referred to as alpha 4. The performance measure is given by CAPM and is adjusted on market risks (Nwogugu, 2018; Lo, 2010). The tool shows the management ability of a company to offer average returns above-market returns. Hence, a higher Jensen measure indicates an excellent risk of the portfolio returns.

Which Measurement Tool Is Better?

There is no perfect measurement tool for measuring portfolio risk and returns. However, the Sharpe ratio is the best risk measurement tool among the three techniques. This is because the ratio adopts both CML and CAPM when assessing risks(Lo, 2010). However, a combination of these tools would give a more precise portfolio performance measure. Thus, the best results will be obtained when the three tools are used together.

Part 4: Market Funds in a Portfolio

Which Fund Outperform the Benchmark?

The calculations in the excel workbook and funds on the third and fourth categories performed better than the benchmark or index.

Which Portfolio Offers the Highest Compensation for Risk?

Fund one offers the most significant value as it has the highest beta implying it is less risky than the other funds.

Which Is the Most Consistent Fund Over Time?

Among the four funds, the first one is the mostconstantfund.

References

Choi, N., Fedenia, M., Skiba, H., & Sokolyk, T. (2017). Portfolio concentration and performance of institutional investors worldwide. Journal of Financial Economics, 123(1), 189-208.

Fisher, J. D., Pettenuzzo, D., & Carvalho, C. M. (2020). Optimal asset allocation with multivariate Bayesian dynamic linear models. Annals of Applied Statistics, 14(1), 299-338.

Goldstein, I., Jiang, H., & Ng, D. T. (2017). Investor flows and fragility in corporate bond funds. Journal of Financial Economics, 126(3), 592-613.

Lo, A. W., Matveyev, E., & Zeume, S. (2019). The Risk, Reward, and Asset Allocation of Nonprofit             Endowment Funds. Reward, and Asset Allocation of Nonprofit Endowment Funds (November 1, 2019).

Lo, A. (2010). Hedge funds: an analytic perspective. Princeton: Princeton University Press.

Nwogugu, M. I. (2018). Informationless Trading and Biases in Performance Measurement: Inefficiency of the Sharpe Ratio, Treynor Ratio, Jensen’s Alpha, the Information Ratio, and DEA-Based Performance Measures and Related Measures. In Indices, Index Funds and ETFs (pp. 233-265). Palgrave Macmillan, London.

Vukovic, D. B., & Prosin, V. (2018). The prospective low-risk hedge fund capital allocation line model: evidence from the debt market. Oeconomia Copernicana, 9(3), 419-439.