Asset Allocation And Portfolio Diversification

Question 1

Building a portfolio using asset allocation models should be built with the following considerations

Answer 1

Clients risk tolerance level and time horizon

Clients level of sophistication with regard to investment alternatives

Required rate of return to meet objectives

Clients financial position and tax situation

Question 2

What is strategic asset allocation?

Answer 2

Purpose of strategic asset allocation is to choose an appropriate asset allocation based on forecast of the economy, expectations of selected asset classes, and the clients risk tolerance

Remain constant until another analysis is conducted

Rebalancing must take place typically occurs once or twice per year

Question 3

What is tactical asset allocation?

Answer 3

Refers to changing the mix of investment classes based on changing market conditions

To market timing , based on the belief that investors can increase returns over time by switching among asset classes

Analyze the different asset classes to determine which ones are thought to be undervalued or overvalued

May generate high transaction turnover cost

Question 4

What is core and satellite asset allocation?

Answer 4

Investment strategy investing in both broad market indexes (Core) in higher risk alternatives (satellite)

Core Investments, include US stocks, US fixed income and developed international equities

Satellite investments, include REITS, emerging markets, high yield bonds

Question 5

What is an efficient asset allocated portfolio?

Answer 5

has the highest level of return for the given level of risk

The return should be in after tax return

Question 6

What is the general asset allocation for a conservative portfolio and who are they appropriate for?

Answer 6

40% money markets, 40% fixed income, 15% large cap equity, 5% international equity

Investor, who has little experience in investing in stocks and bonds, and has little tolerance for volatility in the portfolio

Retired investor who has a significant investment portfolio, capable of generating enough income, and cash flow, to maintain the investors current standard of living

Question 7

What is a general asset allocation for a moderate portfolio and who is it appropriate for?

Answer 7

5% money market, 40% fixed income, 35% large cap equity, 15% international equity, 5% small cap equity

Investor, who has at least some experience investing in stocks and bonds, and is willing to accept additional risk for the possibility of higher expected returns

Investor, who has a relatively high risk tolerance level that is retiring and needs to adjust the portfolio in such a way as to generate higher yields and less capital appreciation

Question 8

What is the general guide for an aggressive asset, allocated portfolio and who is it appropriate for?

Answer 8

20% fixed income, 50% large cap equity, 20% international equity, 10% small cap equity

Investor who has substantial experience investing in stocks and bonds, and is willing to accept a significantly higher level of additional risk for the possibility of higher expected returns

Retired investor who has a significant net worth and a significant investment portfolio, capable of generating enough income, and cash flow from the bond portion of the portfolio to maintain the investors current standard of living the remainder of the portfolios invested for purposes of future growth

Question 9

Modern portfolio theory

A combination of assets were called portfolios and the spectrum of portfolios on the risk return scale created what is known as the what?

Answer 9

The efficient frontier

Question 10

Modern portfolio theory

Every portfolio on the efficient frontier has either two things. What are they?

Answer 10

Higher rate of return for equal risk or lower risk for an equal rate of return than another portfolio below or underneath the frontier

Question 11

Modern portfolio theory

Can a portfolio exist below the efficient frontier?

Answer 11

Yes

Question 12

Can portfolios exist above the efficient frontier?

Answer 12

No, any portfolio above efficient frontier is unattainable

Question 13

Modern portfolio theory

What is an indifference curve?

Answer 13

Curves upward are used to measure the risk reward trade offs that investors are willing to make

Indifference curve will cross the efficient frontier in two locations unless it is tangent to the efficient frontier (Optimal portfolio)

Each investor has an infinite number of indifference curves

Using indifference purse in conjunction with the efficient frontier allows investors to choose the best portfolio for the given level of risk

Question 14

The efficient frontier consist of portfolios with the highest expected return for a given level of risk, what are the three rules for choosing efficient assets?

Answer 14

Two risky assets same expected return: choose the one with the lower risk

Two assets same risk: choose the one with the higher expected return

Choose any asset that has a higher expected return and lower risk

Question 15

Capital asset pricing model (CAPM)

Expands on the concepts of the modern portfolio theory

What is the formula?

Answer 15

Question 16

Capital asset pricing model (CAPM)

What are its assumptions?

Answer 16

All informed investors have uniform expectations regarding the risk return relationship of risky assets

Investors can both borrow and lend at a specific positive risk free rate of return

Transaction cost are equal to zero

Taxes are equal to zero

At all times, markets are in equilibrium, establishing a baseline by which to evaluate the suitability of any investment

Question 17

What is Arbitrage Pricing Theory?

Answer 17

Attempts to explain return expectations in terms of multiple factors or variables

Question 18

Supporters of arbitrage pricing theory, believe what?

Answer 18

That returns for securities are based on a variety of factors that affect different groups of investments

1. Small factors will affect all securities: inflation, interest rates, population growth
2. Other factors may only affect a specific industry.
3. Certain events or factors only affect a single company.

Question 19

What is the efficient market hypothesis?

Answer 19

Investors are unable to consistently out perform the market on a risk adjusted basis

Question 20

Under the efficient market hypothesis, why are investors unable to consistently outperform the market on a risk adjusted basis?

Answer 20

Market efficiency and valuing securities is extremely quick and accurate and does not permit investors to find undervalued stocks on a consistent basis

Stock prices reflect all available information for a company and rapidly adjust to reflect any new information

Question 21

Under the efficient market hypothesis, day-to-day price changes follow random walk pattern. What are these?

Answer 21

Pattern occurs because future events cannot be predicted from past information because current stock prices fully reflect all known information

Price changes are unpredictable and random. If prices move in a random fashion, any trading rules or techniques will be useless.

New information must be unexpected, otherwise it would be reflected in the current stock price

Question 22

What is the week form efficient market hypothesis and what type of information is reflected in price?

Answer 22

Hold that current stock prices have already incorporated all historic publicly available market data

Technical analysis

Question 23

What is the semi strong form of the efficient market hypothesis and what type of information is reflected in price?

Answer 23

Current stock price not only reflects all past historical price data, but also data from analyzing financial statements, industry, and the current economic outlook

Technical and fundamental analysis

Question 24

What is the strong form of the efficient market hypothesis and what type of information is reflected in price?

Answer 24

Hold that stock prices reflect all public information and most private insider information. Therefore, even traders using inside information are unlikely to consistently out perform the market.

Technical and fundamental analysis and insider information

Question 25

What sort of risk does a concentrated portfolio face?

Answer 25

Unsystematic risk

Question 26

What are the strategies for a concentrated portfolio?

Answer 26

Sell the security - High tax cost is usually a deterrent to an outright sale

Gift the stock - donee takes the donor basis, gift tax consequences

Charitable remainder trust (CRT) - charitable deduction is generally created and can be used to offset current income

Put options - method of minimizing, or eliminating downside risk for a security or a portfolio, expensive if they expire worthless, effective for minimizing downside, risk for limited periods of time

Use options collar strategy - writing a call option on a stock can generate premium to pay for the premium on a put option. Call option creates a ceiling on the value of the security, while the put establishes a floor for the value of the security. Will expire and the collar would have to be put back in place after expiration

Exchange fund - allow investors with concentrated portfolios of publicly traded stock with an established market value to contribute the stock to the fund. In exchange, investor will receive a proportional interest in the overall fund. Without incurring a tax liability

Question 27

What is the primary securities market?

Answer 27

Initial sale of new securities issued to the public

Underwriting, investment banking

Question 28

What is the secondary market in security markets?

Answer 28

Provides investors with a method of buying and selling previously issued securities

Question 29

What is a limit order?

Answer 29

Order to purchase a security at or below specified price or to sell a security at or above a specified price

Question 30

What is a stop order?

Answer 30

An order to create a market order if the price of the security reaches a specified level

Question 31

What is a stop limit order?

Answer 31

Order to create a limit order if the price of the security reaches a specified level