Asset Allocation

The main goal of asset allocation is to balance risk and return by diversifying investments across different asset classes.

Diversification is the practice of spreading investments across various assets to reduce risk.

Diversification reduces risk by spreading investments across assets that are not perfectly correlated, thus minimizing the impact of any single asset's poor performance.

Systematic risk is the risk inherent to the entire market or market segment, while unsystematic risk is specific to a single asset or a small group of assets.

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks.

The formula for the CAPM is: $$E(R_i) = R_f + \beta_i (E(R_m) - R_f)$$ where \(E(R_i)\) is the expected return of the investment, \(R_f\) is the risk-free rate, \(\beta_i\) is the beta of the investment, and \(E(R_m)\) is the expected return of the market.

Beta is a measure of an asset's volatility in relation to the overall market.

The Efficient Frontier is a set of optimal portfolios that offer the highest expected return for a defined level of risk.

The risk-free asset allows investors to combine it with risky assets to create a portfolio with a desired level of risk and return.

The Sharpe Ratio is a measure of risk-adjusted return, calculated as the difference between the portfolio return and the risk-free rate, divided by the portfolio's standard deviation.

The formula for the Sharpe Ratio is: $$Sharpe Ratio = \frac{E(R_p) - R_f}{\sigma_p}$$ where \(E(R_p)\) is the expected return of the portfolio, \(R_f\) is the risk-free rate, and \(\sigma_p\) is the standard deviation of the portfolio's excess return.

Dynamic asset allocation is an investment strategy that involves adjusting the mix of assets in a portfolio based on changing market conditions.

Strategic asset allocation is a long-term approach that sets target allocations and rebalances periodically, while tactical asset allocation allows for short-term adjustments based on market conditions.

The purpose of rebalancing a portfolio is to maintain the desired level of asset allocation and risk by periodically buying or selling assets.

The Constant Mix strategy involves maintaining a fixed proportion of the portfolio in different asset classes, regardless of market movements.

The Constant Proportion Portfolio Insurance (CPPI) strategy involves adjusting the allocation between a risky asset and a risk-free asset to ensure a minimum portfolio value.

The formula for the CPPI strategy is: $$Allocation to Risky Asset = m \times (Portfolio Value - Floor Value)$$ where \(m\) is the multiplier.

The main advantage of the CPPI strategy is that it provides downside protection while allowing for participation in market gains.

The main disadvantage of the CPPI strategy is that it may underperform in a steadily rising market due to frequent rebalancing.

The Buy and Hold strategy involves purchasing assets and holding them for a long period, regardless of market fluctuations.

The main advantage of the Buy and Hold strategy is its simplicity and low transaction costs.

The main disadvantage of the Buy and Hold strategy is the potential for significant losses during market downturns.

Risk tolerance determines the appropriate mix of assets in a portfolio based on an investor's willingness and ability to take on risk.

A longer time horizon allows for a higher allocation to riskier assets, as there is more time to recover from potential losses.

Liquidity is important in asset allocation to ensure that investors can meet short-term financial needs without having to sell assets at a loss.