Asset Allocation Strategy - Example

ASSET ALLOCATION STRATEGY Name Institution Asset Allocation Strategy Introduction A well-balanced portfolio promises a good return compared to holding a single stock (Maginn, 2007). Selecting good investments to hold in a portfolio requires a good strategy that helps in analyzing various factors that affect returns of each investment (Chandra, 2008). One need to analyze all the risks associated with all his portfolio investment. Diversification is the best way of reducing risks associated with investments in various assets (Reilly, & Brown, 2012) Goals of the Investment Investment in more than one asset (Portfolio) More assets helps in reducing risks associated with certain assets. Determination of the Investment Risks Investment involves risks and some risks are safer compared to others. However, the higher the risks, the higher the returns an investor receives from his investment. To select an efficient portfolio Investments involve taking risks(Reilly, & Brown, 2012). Therefore, to mitigate risks an investor would prefer investing in more than one asset. This requires selection of an appropriate portfolio. This strategy therefore, aims at selecting an appropriate portfolio that promises an efficient return. To determine covariance of different portfolios Covariance helps in determining whether the assets are positively correlated or negatively correlated. Asset Allocation The selected assets for the investment include: Bonds Stocks (Australian) Alternative Stocks/ Foreign Stock Property Cash Table 1 Year Cash (%) Australian Stock (%) Foreign Stock (%) Property (%) Bonds (%) 2009 3.3 2.0 20.5 9.6 12.5 2008 6.7 16.5 39.7 15.3 17.9 2007 6.4 4.0 14.4 8.9 8.7 2006 6.0 24.7 12.3 34.0 6.4 2005 5.7 21.1 17.6 12.5 3.2 Standard deviation 4.9 7.6 18 18.8 12.5 Table 2: Investment Portfolio based on the Available Funds, Investment Amount Expected Return (%) Beta Probability Bonds 400000 18.6 0.23 0.40 Australian Stocks 200000 10.7 0.60 0.20 Foreign Stock 100000 11.4 0.86 0.10 Property 200000 12.5 0.74 0.20 Cash 100000 9.3 0.16 0.10 Beta = correlation Coefficient between market and asset * Beta for Bonds Bond Price = 18.6% Standard deviation = 5.08% Correlation coefficient between market and Bond price = 0.85 Beta = 0.85 * Beta for Australian Stock Standard deviation of the market = 9.12% Correlation coefficient between market and Australian Stock = 0.70 Australian Stock Price = 10.7% Beta for the Australian Stock = 0.70 * Beta for the Foreign Stock Correlation coefficient between market and Foreign Stock = 0.67 Foreign Stock Price = 11.4% Standard deviation = 9.81% Beta for the Foreign Stock = 0.67 * Beta for the Property Correlation Coefficient between market = 0.81 Property Price = 12.5% Standard deviation of the property = 9.25% Beta of the property = 0.81 * Beta for the Cash Investment Correlation Coefficient between the market and Cash Investment = 0.72 Standard deviation of cash = 1.46% Cash Price = 9.3% Beta for the cash investment = 0.72 * In the tables below, C represents cash, A, represent Australian stock, Y represent Foreign stock, X represents property and R represents bonds. Table 3 C (C -Ḉ)^2 A (A – Â)^2 Y (Y- Ῡ)^2 3.3 5.38 2.0 135.9 20.5 0.16 6.7 1.17 16.5 8.1 39.7 353.44 6.4 0.61 4.0 93.3 14.4 42.25 6.0 0.14 24.7 121.9 12.3 73.96 5.7 0.01 21.1 55.4 17.6 10.89 Ḉ=5.62 7.31 Â = 13.66 414.6 Ῡ=20.9 480.70 Table 4 X (X - Ẋ)^2 R (R -Ṝ)^2 9.60 41.73 12.5 7.62 15.3 0.58 17.9 66.59 8.90 51.27 8.70 1.08 34.00 321.84 6.40 11.16 12.50 12.67 3.20 42.77 Ẋ = 16.06 428.09 Ṝ = 9.74 129.22 Variance and Standard Deviation based on the Markowitz Model Variance for Cash Investment = Standard deviation of Cash Investment = = 1.21 Variance of Australian Stock = Standard deviation of Australian Stock = = 9.12 Variance of Foreign Stock Investment = Standard deviation of Foreign Investment = = 9.81 Variance of Property Investment = Standard deviation of property = = 9.25 Variance of Bonds = Standard deviation of the Bonds = = 5.08 Holding the assets as a Portfolio For Example: Calculation of Covariance based on Markowitz Model Cash and Bonds, foreign Stock and Bonds, Australian Stock and Cash, Property and Cash, Property and Bonds, and Foreign stock and bonds. Covariance = (C -Ḉ) (R -Ṝ)p Where p is the probability Table 5 (C -Ḉ) (R -Ṝ)p (Y- Ῡ) (R -Ṝ)p (A – Â) (C -Ḉ)p (X - Ẋ) (C -Ḉ)p (X - Ẋ) (R -Ṝ)p (Y- Ῡ) (R -Ṝ)p -0.72 -8.98 5.64 -4.88 9.63 -7.98 -4.56 -5.66 -9.67 9.56 -2.56 4.90 6.43 3.99 -3.54 -7.89 4.75 -4.65 0.98 6.78 5.43 3.44 -3.45 -3.65 -6.96 3.43 7.89 5.67 2.43 0.56 Total = -4.83 -0.44 5.75 5.90 10.8 -10.82 From table 5 above, it shows that, the covariance of holding cash and bonds is -4.83. This is an indication that cash and bonds are negatively correlated, move in opposite direction. Therefore, an increase in cash may lead to a decrease in bond, and an increase in bonds may lead to an increase in cash. Holding bonds and foreign stock shows a negative correlation of -10.82. therefore, an changes in incomes of bond and foreign stock moves in an opposite direction. When held together, Australian stock and cash shows a positive correlation, that is, changes in the return of Australian stock and cash moves in the same direction. This movement applies to when an investor holds property and cash in a portfolio and when an investor holds property and bonds. Table 6: Beta for the Portfolio Asset Probability Beta Portfolio Beta Cash 0.1 0.16 0.016 Bond 0.4 0.23 0.092 Australian Stock 0.2 0.60 0.12 Foreign Stock 0.1 0.86 0.086 Property 0.2 0.74 0.148 Total 0.462 Table 7: Expected Portfolio Return Asset Expected Return (%) Probability Portfolio Expected Return (%) Cash 9.3 0.1 0.93 Bond 18.6 0.4 7.44 Australian Stock 10.7 0.2 2.14 Foreign Stock 11.4 0.1 1.14 Property 12.5 0.2 2.5 Portfolio Expected Return 14.15 Analysis The investments in this plan include, cash, Australian stock, foreign stock, bonds and property. Each of the investments exposes the investor to a certain level of risk. The volatility of bonds in this plan is 5.08%, for property is 9.25%, for cash is 1.21%, for Australian stock is 9.12% and that of foreign stock is 9.81%. Therefore, from the volatility it shows that, investing in foreign stocks is more risky among the five assets with a percentage of 9.81%. Property also exposes an investor to a higher risk of 9.12%, followed by Australian stock with 9.12%. Bonds volatility is at, 5.08%. From the calculations, it is evident that cash has the lowest volatility of 1.21. Therefore, to avoid high risks of holding the assets individually, it is advisable to hold them in a portfolio. When held in a portfolio, an investor should invest in portfolio of cash and bonds and foreign stock and bonds. The two portfolio provides negative correlation, an indication that when change in income of one asset moves downwards, the other asset’s return moves upwards. Therefore, one asset is able to cover for the fall in return of another asset when held in a portfolio. Positive correlation shows movement in the same direction. This is very risky to an investor since a decline in return signifies a loss in both the assets. 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