TOPIC 49: ASSET ALLOCATION AND PORTFOLIO DIVERSIFICATION in .NET

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TOPIC 49: ASSET ALLOCATION AND PORTFOLIO DIVERSIFICATION
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1 Strategic asset allocation A This is based on an investment policy that determines a suitable mix of assets for a client s portfolio B Application of client life cycle analysis (1) A client s risk tolerance can be deduced from an analysis of his or her life cycle As discussed in Topic 10, there are four life cycle phases: accumulation phase, consolidation phase, spending phase, and gifting phase (2) In the accumulation phase, individuals are accepting of high-risk investments for above-average returns In the consolidation phase, individuals are accepting of
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Topic 49: Asset Allocation and Portfolio Diversi cation - 163 moderate-risk investments In the spending phase, individuals are accepting of low-risk investments In this phase, the overall portfolio is less risky than during the consolidation years, but individuals still need to have some risky growth investments, such as common stock, for in ation protection The gifting phase risk level is comparable to the spending phase C Client risk tolerance measurement and application (1) It is vital to nd a portfolio that matches the investor s risk tolerance level while helping the investor achieve his or her return objectives (2) In certain cases, measuring risk tolerance can be objective, but it is generally a subjective measure of the emotional and nancial ability of an investor to withstand nancial loss A careful analysis of the client s risk tolerance should precede any discussion of return objectives (3) Asset allocation portfolios are generally marketed as follows: (a) Aggressive growth (b) Growth (c) Growth and income (d) Balanced (e) Fixed income (4) Both the return and risk level decrease as we move from aggressive growth to growth, growth to growth and income, and so on D Asset class de nition and correlation (1) Investments are distributed among three broad asset classes (a) Stocks (b) Bonds (c) Cash and money market instruments (2) The correlation coef cient is the driving force of asset allocation As mentioned earlier, as the correlation coef cient decreases from +1, there is an increase in diversi cation Diversi cation can increase the return of a portfolio while decreasing the risk (3) Keep in mind that the standard deviation of a portfolio is less than the weighted standard deviation of the individual stocks in the portfolio 2 Tactical asset allocation uses security selection as its main approach to building a portfolio, whereas asset allocation uses an investment policy that determines a suitable mix of assets for a client s portfolio 3 Passive versus active portfolio management (see Topic 48) A A passive strategy begins by setting speci c percentages for each asset class The portfolio will be rebalanced occasionally to maintain these percentages A passive strategy should not be confused with a buy-and-hold strategy B An active strategy is often referred to as market timing, whereas tactical asset allocation is driven by security selection as the reason for rebalancing 4 Strategies for dealing with concentrated positions A Rebalancing a portfolio to maintain asset allocation percentages is most appropriate for a tax-deferred retirement account, because gains on the sale of securities are not taxed It is also appropriate for a regular account, but frequent rebalancing may cause complicated tax reporting headaches
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164 - Investment Planning B The basic rule of rebalancing is that it should be used at regular intervals, say every quarter or every six months
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TOPIC 50: EFFICIENT MARKET THEORY (EMH)
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1 Introduction The EMH does not state that an individual cannot outperform the market It states that an individual cannot outperform the market on a risk-adjusted basis over an extended period of time, because security prices fully re ect all available information and are consistent with the risk involved 2 Strong form A The strong-form EMH states that stock prices fully re ect all public and private information The strong form includes all types of information: market, nonmarket public, and private information Not even access to inside information can produce superior returns It assumes that inside information cannot be kept inside B This does not assume an investor cannot be expected to achieve success, only that success should not be expected C An investor who accepts both the semistrong-form and strong-form EMH will generally avoid all active managers inasmuch as superior returns cannot be expected 3 Semistrong form A The semistrong-form EMH states that stock prices fully re ect all public information Security prices include market and nonmarket public information This includes a company s past history and information learned from studying nancial statements, the industry, and the economic environment B An investor cannot expect to achieve superior returns using fundamental analysis This does not assume that an individual cannot achieve superior returns, just that superior returns should not be expected 4 Weak form A The weak form assumes that stock prices fully re ect all available market information The weak-form EMH believes that security returns are independent of each other and that correlation between stock prices over time is virtually nothing B The weak form can be explained by the random walk theory Historical, price behavior, and technical indicators cannot produce superior returns Information utilized by technical analysis has no predictive value C The weak-form EMH does state that using good research may produce superior returns; fundamental analysis may have value 5 Anomalies A Tests of the EMH (1) Testing the weak-form EMH (a) Statistical tests of the independence of security returns (b) Trading rule tests to examine whether mechanical trading rules can generate excess returns (2) Testing the semistrong-form EMH (a) Time-series tests and cross-sectional tests to predict future rates of return based on public information
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Topic 51: Asset Pricing Models - 165 (b) Event studies that examine the stock price reaction to signi cant economic events such as stock splits, initial public offerings, exchange listings, and announcements of dividend and accounting changes (3) Testing the strong-form EMH Academic tests are used to look at the legal use of private information and exclude illegal insider trading Anomalies from time-series tests (1) Studies show that dividend yield, default spread, and term structure spread can be used to determine the returns on stocks and bonds (2) Quarterly earnings reports show that the market may not have adjusted stock prices as quickly as expected to re ect earning surprises (3) The January effect shows that stocks tend to perform well in January To take advantage of the January effect, investors would buy securities in December and sell in January There is also a day of the week effect (or weekend effect) Research has suggested that the weekend generates a lower return This implies that investors anticipating the purchase of a stock should not purchase the stock on Friday, but wait until Monday Anomalies from cross-sectional tests (1) The P/E effect shows that low P/E stocks produce superior returns relative to the market, and high P/E stocks produce inferior returns (2) The small- rm effect (or small cap) indicates that small rms consistently produce superior returns relative to larger rms The return of a rm diminishes as its market capitalization gets bigger (3) The neglected rm effect states that a rm that has a small number of analysts following it tends to produce higher returns than those rms covered by many analysts (4) Stocks with high book-to-price ratios have a higher risk-adjusted return, representing evidence against the EMH Anomalies from strong-form academic tests (1) Stock exchange specialists have monopolistic access to information and derive aboveaverage returns from the information (2) Corporate insiders also have monopolistic access to information, which produces excess returns Conclusions of the three forms of market ef ciency (1) Results support the weak-form EMH (2) Results are mixed for the semistrong form of the EMH Event studies support the semistrong-form EMH, but time-series and cross-sectional tests give evidence that markets are not always semistrong-form ef cient (3) Results support the strong-form EMH except for corporate insiders and specialists
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