Strategic Asset Allocation: Determining the Optimal Portfolio with Ten Asset Classes

This paper will assess my ability to maximize my personal return on investment with an allocation of $1,000,000. The overall goal of this exercise is to obtain the highest return possible within the next 12 months. I am limited to the following asset classes for allocation of all investments:

The extracted data used includes monthly returns from January 1972 to July 2011. The assets are selected so that the portfolio contains the largest, most liquid, and most tradable assets. The choice of such a variety of assets across several markets was used in order to generate a large cross sectional dispersion in average return. It helped to reveal new factor exposure and define a general framework of the correlated value and momentum effects in various asset classes.

Advisors and investors would do well to pay as much attention to the expected volatility of any portfolio or investment as they do to anticipated returns. Moreover, all things being equal, a new investment should only be added to a portfolio when it either reduces the expected risk for a targeted level of returns, or when it boosts expected portfolio returns without adding additional risk, as measured by the expected standard deviation of those returns. Lesson 2: Don’t assume bonds or international stocks offer adequate portfolio diversification. As the world’s financial markets become more closely correlated, bonds and foreign stocks may not provide adequate portfolio diversification. Instead, advisors may want to recommend that suitable investors add modest exposure to nontraditional investments such as hedge funds, private equity and real assets. Such exposure may bolster portfolio returns, while reducing overall risk, depending on how it is structured. Lesson 3: Be disciplined in adhering to asset allocation targets. The long-term benefits of portfolio diversification will only be realized if investors are disciplined in adhering to asset allocation guidelines. For this reason, it is recommended that advisors regularly revisit portfolio allocations and rebalance

“The Benefits of diversification are clear. Portfolio theory has played a crucial role in explaining the relationship between risk and return where more than one investment is held. It also enables us to identify optimal and efficient portfolios.”

Week 1 – Introduction – Financial Accounting (Review) Week 2 – Financial Markets and Net Present Value Week 3 – Present Value Concepts Week 4 – Bond Valuation and Term Structure Theory Week 5 – Valuation of Stocks Week 6 – Risk and Return – Problem Set #1 Due Week 7* – Midterm (Tuesday*) Week 8 - Portfolio Theory Week 9 – Capital Asset Pricing Model Week 10 – Arbitrage Pricing Theory Week 11 – Operation and Efficiency of Capital Markets Week 12 – Course Review – Problem Set #2 Due

Our approach is an active security selection with passive asset allocation. We invest heavily in common stocks, but vary our holdings to include companies of all sizes and industry groups. We seek to achieve sufficient diversification by abstaining from investing more than 5% of the total assets in a single security unless it has significant upside potential, and we make an exception for ETFs and index funds as they represent a basket of securities. Our main goal is to identify and invest in common stocks with high potential for both short- and long-term capital appreciation. Our secondary goal is to invest in common stocks with steady income. When potential for rewards are high, we also enter into derivative

I strongly advocate tactical asset allocation process and diversification over several different income and growth strategies. I believe that risk management and protection of investor's endowment are major objectives. In my portfolio, stocks may occupy a large portion and the

In order to find the optimal portfolio allocation, the group needs to find the portfolio structured with lowest risk under a given return. This can be achieved by applying Mean-Variance Theory and Markowitz model find the efficient frontier, which yields the most optimal portfolio under given returns. It can be expressed in mathematical terms and solved by quadratic programming. [Appendix A]

The learning objectives for students in this course are: (l) improve your understanding of financial securities and markets, (2) develop the ability to analyze investment companies, common stocks, and bonds for investment decisions, (3) understand how options are

‘The Capital asset pricing model (CAPM) is a very useful model and it is used widely in the industry even though it is based on very strong assumptions. Discuss in the light of recent developments in the area.’

The success of the model is attributed to Yale’s ability to combine both quantitative analysis (mean-variance analysis) with market judgments to structure its portfolio. In addition, Yale also uses statistical analysis to actively test their models with factors affecting the market, therefore understanding the sensitivity of their portfolio in response to various market changes. Yale also follows and forecasts the cash flow of private equity and real assets in its portfolio to decide the need for hedging.

To reduce a firm’s specific risk or residual risk a portfolio should have negative covariance or rather it should have no variance at all, for large portfolios however calculating variance requires greater and sophisticated computing power. As such, Index models greatly decrease the computations needed to calculate the optimum portfolio. The use of such Index models also eliminates illogical or rather absurd results. The Single Index model (SIM) and the Capital Asset Pricing Model (CAPM) are such models used to calculate the optimum portfolio.

This research has important implications for Buy and Maintain fixed income investing. While there are many more attributes to take into account when choosing fixed income securities (multiple issues per issuer based on tenor, subordination, etc.), each fixed income security has arguably less idiosyncratic factors driving its return than an equivalent equity security. When building a Buy and Maintain portfolio that is resilient to various economic environments and stages of the business cycle, one must therefore draw from the entire global fixed income market; and, the global bond universe is huge. But how many issuers are needed to achieve a well diversified Buy and Maintain portfolio?

As a result, many different factors have been tested across different markets. Historically, most studies have relied on general economic theories or empirical observations in selecting Factors. Benaković and Posedel (2010) emphasize Interest rates, oil prices, and industrial production. Chen, Roll and Ross (1986) use industrial production growth, inflation, bonds spread, NYSE stock market returns, oil prices, interest term structure, and consumption to decompose returns of a portfolio with general securities. Bodurtha, Cho and Senbet (1989) even uses international factors. Most of literatures have focused on applying different factors with a portfolio of many securities, as it is widely known that idiosyncratic risks diversifies away as the number of

Over the last 50 years, Markowitz’s mean-variance optimization framework has become the asset allocation model of choice. Unfortunately the model often leads to highly concentrated asset allocations, the primary reason that practitioners haven’t fully embraced this Nobel Prize winning idea. Two relatively new techniques that help practitioners develop robust, well-diversified asset allocations are the BlackLitterman model and