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Asset Allocation
Chapter Objectives
Explain how diversification among assets can reduce risk
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Asset allocation: the process of allocating money across financial assets with the objective of achieving a desired return while maintaining risk of a tolerable level
Building a portfolio
Portfolio: a set of multiple investments in different assets
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Compare return on the investments within the portfolio to the overall portfolio Diversification reduces the exposure of your investments to the adverse effects of any individual investment
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How Diversification Reduces Risk (contd) Factors that influence diversification benefits
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Financial Planning Online: Correlations among Stock Returns Go to: http://finance.yahoo.com/?u This Web site provides a graph that shows the returns on two stocks so that you can determine their degree of correlation. To perform your own comparison, insert a stock symbol, and then click on Charts
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Financial Planning Online: Correlations among Stock Returns (contd) Next, enter the symbol for another stock in the box just below the chart where is says Compare
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Less risky than a portfolio of stocks all from the same industry
Even such a portfolio is still susceptible to general economic conditions
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Strategies for Diversifying Among Stocks (contd) Diversification of stocks across countries
Economic conditions tend to vary among countries Foreign stocks typically more volatile than U.S. stocks so it is best to diversify among stocks within each foreign country Many advisors recommend an 80/20 split between U.S. and foreign stocks
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Bond and stock returns are not highly correlated Investing in more bonds lowers market risk but increases interest rate risk
Real estate investment trusts (REITs): trusts that pool investments from individuals and use the proceeds to invest in real estate
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Types of REITs
Equity REITs: REITs that invest money directly in properties
Mortgage REITs: REITs that invest in mortgage loans that help to finance the development of properties
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Stock option: an option to purchase or sell stocks under specified conditions Traded on exchanges Call option: provides the right to purchase 100 shares of a specified stock at a specified price by a specified expiration date
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Exercise (strike) price: the price at which a stock option is exercised Premium: the price that you pay when purchasing a stock option Put option: provides the right to sell 100 shares of a specified stock at a specified price by a specified date
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Very risky; should only pay a minimal role in asset allocation Covered call strategy: selling call options on stock that you own To maintain a low risk, asset allocation should emphasize low risk investments
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Factors That Affect the Asset Allocation Decision Your stage in life
Younger investors need safer, more liquid securities Investors not needing liquidity might consider investing in securities with high growth potential Investors nearing retirement may choose investments that will generate income
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This Web site provides a personal recommended asset allocation considering your income, your stage in life, and other characteristics once you input some basic information
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How Asset Allocation Fits within Your Financial Plan Key decision concerning asset allocation for your financial plan are:
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