BUS601: Financial Management

The expected return of a diversified portfolio is the expected return of each of its underlying investments times the weight the investment receives.

Learning Objective

• Calculate the expected returns of an investment portfolio

Key Points

• Asset allocation is a theory of designing a portfolio that achieves a weighting scheme with a target mix of different asset classes that is suitable to the time frame and risk tolerance of the investor.
• The principles that support the theory of asset allocation are the cyclical nature of investments within a particular class of assets and weaker or even negative correlations that often exist across asset classes.
• When you rebalance your portfolio after it has deviated from the original target mix, you are selling classes that have relatively appreciated in order to buy those which have relatively depreciated.
• If you believe that markets go in cycles, you should believe in selling assets that have relatively appreciated and buying those which have relatively depreciated.

Term

• Strategic Asset Allocation

The primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon.

Asset allocation is the theory that any portfolio should have a set of target weights for different asset classes based on time frame and risk tolerance. There are two key principles at work in this theory. The first is that everything goes in cycles and the second is that often when one thing is ebbing, the other is flowing. Let's make this very simple and say that bonds return 4% in a bad year, 6% in an average year, and 8% in a good year, and stocks return -5% in a bad year, 10% in an average year, and 15% in a good year.

Stocks have cycles and when stocks do well, bonds are more likely to do poorly and vice versa. Let's say we have a portfolio of $100,000 that has a target mix of 60% stocks and 40% fixed income and, therefore, has $60,000 in stocks and 40,000 bonds. Stocks have a good year and bonds have a bad one, and now we have 40,000 bonds. Stocks have a good year and bonds have a bad one, and now we have 69,000 invested in stocks and 41,600 in bonds. At this point, we have a total portfolio of 41,600 in bonds. At this point, we have a total portfolio of 41,600 in bonds. At this point, we have a total portfolio of 110,600 and an asset mix of roughly 62% stocks and 38% bonds. We began with a target mix of 60-40 but since the equity market fared better than fixed-income market, we are a little off-balance. So how do we fix that? We could sit and wait and watch what happens, or we could shift 2,640 from our equity position to a fixed−income position. Remember, things go in cycles, so we expect that if stocks do well relative to bonds that sometime in the future, bonds will do well relative to stocks. By shifting 2,640 from our equity position to our fixed-income position, we are essentially selling stocks after they have appreciated (at a high) and buying bonds after they have failed to appreciate (at a low). Look at how the different asset mixes fare, based on a 10-year period that is consistent with historical averages.

Average Returns for Different Weighting Schemes
Different returns are expected for different asset allocations given historical averages

Assuming rebalancing, the expected return of a diversified portfolio is simply the expected return of each of its underlying investments times the allocation weight the investment receives.

The theory can feature different strategies, including strategic asset allocation, tactical asset allocation, and others, but the ideas are the same as the implications for return. A portfolio should consist of a variety of classes of assets to take advantage of zero and negative correlations between those classes, and it should be designed to achieve a target mix of assets that are rebalanced when one grows in relation to another.

Source: Boundless.
This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 License.