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Asset Allocation and

Investment Policy

An investment strategy is based on fourdecisions1. What asset classes to consider for investment

2. What normal or policy weights to assign to each eligible class

3. The allowable allocation ranges based on policy weights

4. What specific securities to purchase for the portfolio

85% to 95% of the overall investment return isdue to the first two decisions, not the selectionof individual investments

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Asset Allocation

Strategies

Integrated asset allocation

capital market conditions

investors objectives and constraints

Strategic asset allocationconstant-mix

Tactical asset allocation

mean reversion

inherently contrarian

Insured asset allocation

constant proportion portfolio insurance

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Integrated asset allocation

Capital Market

Conditions (C1)

Prediction

Procedure (C2)

E(R), Risk,

Correlations (C3)

Investors Risk

Tolerance (I3)

Investor Risk

ToleranceFunction (I2)

Investor Assets,

Liab., Net Worth

(I1)

Optimizer (M1)

Investors Asset Mix (M2)

Realized Returns (M3)

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Strategic asset allocation

Used to develop a long-term policy allocation

Example: Portfolio will always rebalance to

revert to a 60% Stock/30% Bond/10% Cashallocation

Practical issues:

Frequency of rebalancing

Reevaluation of the policy allocation

ex. Northeasterns endowment

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Tactical asset allocation

Used to develop short-term strategies to exploit changesin market conditions

Often viewed as a contrarian strategy

Assume asset class performance is mean-reverting

if stocks have performed above average relative to bonds,underweight stocks and overweight bonds for next period

Assume stocks will generate above average returns

overweight stocks!

Practical issues:

Frequency of rebalancing

Constraints on swing component

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Insured asset allocation

Used to develop short-term strategies to exploit changesin investors objectives and constraints

This is a portfolio insurance strategy

Assumes investors become more risk-tolerant as wealth rises

if stocks have performed above average relative to bonds,overweight stocks for next period

Assumes investors become less risk-tolerant as wealth falls

If stocks have performed poorly, underweight in next period

Practical issues:

Frequency of rebalancing

Liquidity

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Which Allocation Strategy is Best?

Define $ invested in stocks (S)

S = m(A - F)

where A = total asset value

F = floor value for assets

m = multiplier

B = $ invested in riskless bonds (=A-S)

Three Strategies (A=100):

Buy and Hold (m=1, F=40)

Constant Mix (m=.6, F=0)

Portfolio Insurance (m=2, F=70)