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Chapter 5
The Theory of Portfolio Allocation
Portfolio
• A portfolio is the set of financial assets that
are owned by an individual.
• This chapter briefly discusses the
determinants of the amount and types of
assets that agents keep in their portfolio.
Determinants of Portfolio Choice
1. Wealth – Overall amount of financial
assets
2. Expected Returns on Assets
3. Risk of Assets
4. Liquidity of Assets
5. Costs of Acquiring Information
Wealth
• Tautologically, the greater the wealth of an
investor the larger is his portfolio in dollar
terms.
• An increase in aggregate wealth increases
aggregate demand for all types of assets.
• However, an increase in wealth might not
have an equal effect on all assets.
Wealth Elasticity of Demand
• We calculate the wealth elasticity of an
asset as
ASSET
W EALTH
DEMAND

% Increase in Demand for Asset
% Increase in Wealth
ASSET
WEALTH
DEMAND
• If
< 1, necessity asset (checking
accounts)

• If
> 1, luxury asset (stocks)
ASSET
WEALTH
DEMAND
Expected Return on Assets
• The greater is the relative return on an asset,
all else equal, the more of that asset that you
would like to hold in your portfolio.
• Demand for an asset depends on its relative
expected return.
• Agents care about real returns (i.e. total
return – inflation rate).
Risk
• Exchange Fund Bills have circulated for 1 decade. The
average yield for holding 1 year exchange fund bills is
5.61%.
• Average return on a portfolio matching the Hang Seng
Index during this time is 22.65%
• Why would anyone buy exchange fund bills.
• The reason is that though the average was much higher for
stocks, stocks were much more unpredictable. If you
decide to hold a 1 year Exchange Fund Bill in your
portfolio, you know the 1 year yield when you buy the bill.
If you decide to hold a stock index fund, you do not know
the 1 year return.
• Maximum y-o-y Hang Seng Return –12/92-12/93 117.64%
• Minimum y-o-y Hang Seng Return – 7/97 –7/98 - 46.59%
• Most Recent y-o-y Return – 8/00 –8/01 -32.40%
120
80
40
0
-40
-80
92
93
94
95
96
Exchange Fund Yield
97
98
99
00
01
Hang Seng Yield
Risk Aversion
• Compare two assets. Both have the same expected
return. One has a more volatile return than the
other. If
– You prefer the more predictable return, you are risk
averse.
– You are indifferent, you are risk neutral.
– You prefer the more unpredictable return, you are risk
loving.
• Most people are thought to be risk averse, which is
why risky assets must offer higher returns.
Liquidity
• Liquidity is the cost, in terms of time and money
of converting an asset into cash at any time.
• Since no one is ever certain about their future cash
needs for transactions, people prefer liquid assets.
• Liquid assets are thought to be assets for which
there are thick markets – I.e assets with many
buyers or sellers.
Cost of Information
• To efficiently match an asset to your portfolio, you
need information about that asset.
• The costlier that information is to obtain, the less
of that asset you will prefer to hold in your
portfolio.
• Most people’s stock portfolio’s are heavily loaded
toward domestic equity. Presumably, it is easier to
obtain information about domestic companies.