Asset Allocation And Portfolio Diversification Flashcards
Building a portfolio using asset allocation models should be built with the following considerations
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
What is strategic asset allocation?
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
What is tactical asset allocation?
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
What is core and satellite asset allocation?
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
What is an efficient asset allocated portfolio?
has the highest level of return for the given level of risk
The return should be in after tax return
What is the general asset allocation for a conservative portfolio and who are they appropriate for?
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
What is a general asset allocation for a moderate portfolio and who is it appropriate for?
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
What is the general guide for an aggressive asset, allocated portfolio and who is it appropriate for?
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
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?
The efficient frontier
Modern portfolio theory
Every portfolio on the efficient frontier has either two things. What are they?
Higher rate of return for equal risk or lower risk for an equal rate of return than another portfolio below or underneath the frontier
Modern portfolio theory
Can a portfolio exist below the efficient frontier?
Yes
Can portfolios exist above the efficient frontier?
No, any portfolio above efficient frontier is unattainable
Modern portfolio theory
What is an indifference curve?
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
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?
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
Capital asset pricing model (CAPM)
Expands on the concepts of the modern portfolio theory
What is the formula?
Capital asset pricing model (CAPM)
What are its assumptions?
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
What is Arbitrage Pricing Theory?
Attempts to explain return expectations in terms of multiple factors or variables
Supporters of arbitrage pricing theory, believe what?
That returns for securities are based on a variety of factors that affect different groups of investments
- Small factors will affect all securities: inflation, interest rates, population growth
- Other factors may only affect a specific industry.
- Certain events or factors only affect a single company.
What is the efficient market hypothesis?
Investors are unable to consistently out perform the market on a risk adjusted basis
Under the efficient market hypothesis, why are investors unable to consistently outperform the market on a risk adjusted basis?
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
Under the efficient market hypothesis, day-to-day price changes follow random walk pattern. What are these?
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
What is the week form efficient market hypothesis and what type of information is reflected in price?
Hold that current stock prices have already incorporated all historic publicly available market data
Technical analysis
What is the semi strong form of the efficient market hypothesis and what type of information is reflected in price?
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
What is the strong form of the efficient market hypothesis and what type of information is reflected in price?
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
What sort of risk does a concentrated portfolio face?
Unsystematic risk
What are the strategies for a concentrated portfolio?
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
What is the primary securities market?
Initial sale of new securities issued to the public
Underwriting, investment banking
What is the secondary market in security markets?
Provides investors with a method of buying and selling previously issued securities
What is a limit order?
Order to purchase a security at or below specified price or to sell a security at or above a specified price
What is a stop order?
An order to create a market order if the price of the security reaches a specified level
What is a stop limit order?
Order to create a limit order if the price of the security reaches a specified level
