Download Chapter 18

Chapter 18
Asset Allocation
Copyright ©2004 Pearson Education, Inc. All rights reserved.
Chapter Objectives
• Explain how diversification among
assets can reduce risk
• Describe strategies that can be used
to diversify among stocks
• Explain asset allocation strategies
• Identify factors that affect your asset
allocation decisions
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How Diversification Reduces
Risk
• Benefits of portfolio diversification
– Asset allocation: the process of allocating
money across financial assets with the
objective of achieving a desired return
while maintaining risk of a tolerable level
– Building a portfolio
• Portfolio: a set of multiple investments in
different assets
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How Diversification Reduces
Risk
– Focus on Ethics: The risk of insider trading
• Insider information: information known by
insiders (such as managers) of a firm, but not
known by investors
• Investors can legally only use information that
is publicly available
• Securities and Exchange Commission
prosecutes violators
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How Diversification Reduces
Risk
• Determining portfolio benefits
– Compare return on the investments within
the portfolio to the overall portfolio
– Diversification reduces the exposure of
your investments to the adverse effects of
any individual investment
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How Diversification Reduces
Risk
Exhibit 18.1:
Example of Portfolio Diversification Effects
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How Diversification Reduces
Risk
• Factors that influence diversification
benefits
– Volatility of each individual stock
– Impact of correlations among stocks
• Highly correlated stocks limit diversification
• Consider stocks that are not influenced by the
same conditions
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How Diversification
Reduces Risk
Exhibit 18.2: Impact of a Stock’s Volatility on Portfolio Diversification Effects
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How Diversification
Reduces Risk
Exhibit 18.3: Impact of Stock Correlations on Portfolio Diversification Effects
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Financial Planning Online:
Correlations among Stock Returns
• Go to: http://finance.yahoo.com/?u
• This Web site provides a graph that
shows the returns on two stocks so that
you can determine their degree of
correlation. To perform your own
comparison, insert a stock symbol, and
then click on “Charts.”
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Financial Planning Online:
Correlations among Stock Returns
• Next, enter the symbol for another stock
in the box just below the chart where is
says “Compare.”
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Strategies for Diversifying
• Diversification of stocks across
industries
– Less risky than a portfolio of stocks all
from the same industry
– Even such a portfolio is still susceptible
to general economic conditions
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Strategies for Diversifying Among
Stocks
Exhibit 18.4: Benefits of Portfolio Diversification
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Strategies for Diversifying Among
Stocks
• Diversification of stocks across
countries
– Economic conditions tend to vary
among countries
– Foreign stocks typically more volatile
than U.S. stocks so it is best to diversify
among stocks within each foreign country
– Many advisors recommend an 80/20 split
between U.S. and foreign stocks
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Strategies for Diversifying Among
Stocks
Exhibit 18.5:
Benefits from International Stock
Diversification
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Asset Allocation Strategies
• Including bonds in the portfolio
– Bond and stock returns are not highly correlated
– Investing in more bonds lowers market risk
but increases interest rate risk
• Including real estate investments in the
portfolio
– Real estate investment trusts (REITs): trusts that
pool investments from individuals and use the
proceeds to invest in real estate
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Asset Allocation Strategies
– Similar to closed-end mutual funds
– Managed by real estate professional
– Types of REITs
• Equity REITs: REITs that invest money directly
in properties
• Mortgage REITs: REITs that invest in mortgage
loans that help to finance the development
of properties
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Asset Allocation Strategies
– Role of REITs in asset allocation
• REITs could perform well when stocks or bonds
are performing poorly
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Asset Allocation Strategies
• Stock option: an option to purchase or
sell stocks under specified conditions
– Traded on exchanges
• How asset allocation affects risk
– To maintain a low risk, asset allocation
should emphasize low risk investments
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Asset Allocation Strategies
• Benefits of asset allocation
– Investors who diversify experience better
performance
• An affordable way to conduct asset
allocation
– Invest in different types of mutual funds
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Asset Allocation Strategies
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Asset Allocation Strategies
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Factors That Affect the Asset
Allocation Decision
• Your stage in life
– Younger investors need safer, more liquid
securities
– Investors not needing liquidity might
consider investing in securities with high
growth potential
– Investors nearing retirement may choose
investments that will generate income
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Factors That Affect
the Asset Allocation Decision
• Your degree of risk tolerance
• Your expectations about economic conditions
– If you expect a strong stock market, invest in
stocks
– If you expect a weak stock market, invest in bonds
– If you expect lower interest rates, invest in
long-term bonds
– If you expect favorable real estate conditions,
invest in REITs
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Factors That Affect
the Asset Allocation Decision
Exhibit 18.8: Asset Allocation over Time
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Financial Planning Online:
Advice on Your Asset Allocation
• Go to:
http://moneycentral.msn.com/investor/calcs/
assettall/main.asp
• This Web site provides a personal
recommended asset allocation
considering your income, your stage in
life, and other characteristics once you
input some basic information.
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How Asset Allocation Fits within
Your Financial Plan
• Key decision concerning asset
allocation
for your financial plan are:
– Is your present asset allocation of
investments appropriate?
– How will you apply asset allocation in the
future?
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Integrating Key Concepts
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Integrating Key Concepts
• Part 1: Financial Planning Tools
• Part 2: Liquidity Management
• Part 3: Financing
• Part 4: Protecting Your Assets and Income
• Part 5: Investing
– In Chapter 13 we learned about investment fundamentals
– In Chapter 14 we learned about stock analysis and valuation
– In Chapter 15 we learned about investing in stocks
– In Chapter 16 we learned about investing in bonds
– In Chapter 17 we learned about investing in mutual funds
– In Chapter 18 we learned about cover asset allocation
• Part 6: Retirement and Estate Planning
Call Options
• Call option: an option on a specified
stock that provides the right to purchase
100 shares at a specified price by a
specified expiration date
– Exercise (strike) price: the price specified
for exercising a stock option
– Premium: the price that you pay when
purchasing a stock option
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Including Stock Options in Your
Asset Allocation
• Selling a call option — seller obligated
to sell the shares of the specified stock
to the buyer for the exercise price if and
when the buyer exercises the option
• Gain or loss from trading call options
– Determined by the amount received when
the stock is sold, the amount paid for the
stock and the amount paid for the premium
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Put Options
• Put option: an option on a specified
stock that provides the right to sell 100
shares at a specified price by a
specified expiration date
• Selling a put option
– Seller obligated to buy the shares of the
specified stock from the buyer of the put
option for the exercise price if and when
the buyer exercises the option
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Put Options
• Gain or loss from trading put option
– Net gain or loss can be determined by
considering the amount received when you
sell the stock, the amount you paid for the
stock and the amount you paid for the
premium
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Quotations of Stock Options
• Column 1 — name of stock
• Column 2 — exercise price
• Column 3 — expiration date
• Column 4 — volume of contracts traded
• Column 5 — latest quoted premium of
call options
• Column 6 — volume of put options
• Column 7 — latest quoted premium of
put options
Quotations of Stock Options
Exhibit 18.A1: An Example of Stock Option
Quotations
Copyright © 2001 Dow Jones & Company, Inc. All Rights
Reserved.
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Quotations of Stock Options
• In the money: a stock option that can be
exercised profitably
• Out of the money: a stock options that
cannot be exercised profitably
• At the money: an option on a stock
whose prevailing price is equal to the
option’s exercise price
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Factors That Affect the Option
Premium
• Stock price relative to exercise price
• Option’s time to expiration
– A longer maturity results in a higher
premium
• Stock’s volatility
– Highly volatile stocks result in higher
premiums
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The Role of Stock Options in
Asset Allocation
• Very risky; should play only minimal role
in asset allocation
• Buying put options on stocks you own
limits your risk
• Buying call options on stocks you own
reduces your risk
– Covered call strategy: selling call options
on stock that you own
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