Chapter 1
Asset Allocation
An Introduction
Asset allocation has different aims depending on the investor. A younger investor may want to build wealth over time, taking risks that would not be sensible for an older investor. Investors in retirement often want to hunker down to make sure that no unreasonable losses occur. The assets these two investors choose may not differ overall, but the relative weights given to each asset in the portfolio will surely differ a lot. For example, a younger investor will hold a higher proportion of equities than an investor nearing retirement. Institutional investors also differ in their investment strategies. One endowment, perhaps a family foundation, may want to preserve wealth if there are few opportunities to raise more funds in the future. Another endowment, perhaps a university endowment, may follow more aggressive investment policies knowing that there is a steady flow of additional funds from future donors.
This tradeoff between return and risk is central to all asset allocation. It’s a genuine tradeoff even though some investors believe they can achieve returns without taking on risk. Asset allocation aims to find ways to make the tradeoff as attractive as possible. One key concept is the correlation between one asset and another. Almost every portfolio has substantial investments in both stocks and bonds because they tend to be low in correlation with one another. Many portfolios include both foreign and domestic assets for the same ...
