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Chapter 19

Asset Allocation

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Copyright 2007 Pearson Addison-Wesley. All rights reserved. 19-2

Chapter Objectives

Explain how diversification amongassets can reduce risk

Describe strategies that can be usedto 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 theobjective of achieving a desired returnwhile maintaining risk of a tolerable level

Building a portfolio Portfolio: a set of multiple investments in

different assets

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How DiversificationReduces Risk (contd)

Focus on Ethics: The risk of insider trading Insider information: information known by

insiders (such as managers) of a firm, but notknown by investors

Investors can legally only use information thatis publicly available

Securities and Exchange Commissionprosecutes violators

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Determining portfolio benefits

Compare return on the investments within

the portfolio to the overall portfolioDiversification reduces the exposure of your investments to the adverse effects of any individual investment

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Factors that influence diversificationbenefits

Volatility of each individual stockImpact of correlations among stocks

Highly correlated stocks limit diversification Consider stocks that are not influenced by the

same conditions

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Financial Planning Online: Correlationsamong Stock Returns

Go to: http://finance.yahoo.com/?u This Web site provides a graph that

shows the returns on two stocks so thatyou can determine their degree of correlation. To perform your own

comparison, insert a stock symbol, andthen click on Charts
http://finance.yahoo.com/?uhttp://finance.yahoo.com/?u

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Financial Planning Online: Correlationsamong Stock Returns (contd)

Next, enter the symbol for another stockin the box just below the chart where issays Compare

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Strategies for Diversifying Among Stocks

Diversification of stocks acrossindustries

Less risky than a portfolio of stocks allfrom the same industry

Even such a portfolio is still susceptible

to general economic conditions

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Strategies for Diversifying Among Stocks (contd)

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Strategies for Diversifying Among Stocks (contd)

Diversification of stocks acrosscountries

Economic conditions tend to varyamong countries

Foreign stocks typically more volatilethan U.S. stocks so it is best to diversify

among stocks within each foreign countryMany advisors recommend an 80/20 splitbetween U.S. and foreign stocks

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Asset Allocation Strategies

Including bonds in the portfolioBond and stock returns are not highly correlated

Investing in more bonds lowers market riskbut increases interest rate risk

Including real estate investments inthe portfolio

Real estate investment trusts (REITs): trusts thatpool investments from individuals and use theproceeds to invest in real estate

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Asset Allocation Strategies (contd)

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 thedevelopment of properties

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Role of REITs in asset allocation REITs could perform well when stocks or

bonds are performing poorly

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Including stock options in the portfolio

Stock option: an option to purchase or sell

stocks under specified conditionsTraded on exchanges

Call option: provides the right to

purchase 100 shares of a specified stockat a specified price by a specifiedexpiration date

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Exercise (strike) price: the price at whicha stock option is exercised

Premium: the price that you pay whenpurchasing a stock option

Put option: provides the right to sell 100shares of a specified stock at a specifiedprice by a specified date

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The role of stock options inasset allocation

Very risky; should only pay a minimal rolein asset allocationCovered call strategy: selling call optionson stock that you own

How asset allocation affects riskTo maintain a low risk, asset allocationshould emphasize low risk investments

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Benefits of asset allocationInvestors who diversify experiencebetter performance

An affordable way to conductasset allocation

Invest in different types of mutual funds

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Factors That Affectthe Asset Allocation Decision

Your stage in life

Younger investors need safer, more

liquid securitiesInvestors not needing liquidity mightconsider investing in securities with highgrowth potential

Investors nearing retirement may chooseinvestments that will generate income

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Factors That Affectthe Asset Allocation Decision (contd)

Your degree of risk tolerance Your expectations about economic conditions

If you expect a strong stock market, investin stocks

If you expect a weak stock market, invest in bonds

If you expect lower interest rates, invest inlong-term bondsIf you expect favorable real estate conditions,invest in REITs

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Financial Planning Online: Advice on Your Asset Allocation

Go to: http://moneycentral.msn.com/investor/calcs/assetall/main.asp

This Web site provides a personalrecommended asset allocationconsidering your income, your stage inlife, and other characteristics once youinput some basic information
http://moneycentral.msn.com/investor/calcs/assetall/main.asphttp://moneycentral.msn.com/investor/calcs/assetall/main.asphttp://moneycentral.msn.com/investor/calcs/assetall/main.asphttp://moneycentral.msn.com/investor/calcs/assetall/main.asphttp://moneycentral.msn.com/investor/calcs/assetall/main.asp

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How Asset Allocation Fits within Your Financial Plan

Key decision concerning assetallocation for your financial plan are:

Is your present asset allocation of investments appropriate?

How will you apply asset allocation inthe future?

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