Introduction to Asset Allocation & Portfolio Management

DEFINITIONS

ASSET ALLOCATION

Asset Allocation is the process of determining optimal allocations for the broad categories of assets (such as Stocks, Bonds, Cash, Real Estate, ...) that suit your investment time horizon and risk tolerance. 

While this process can be performed on any portfolio with two or more assets, it is most commonly applied to asset classes.  This allocation is probably the most important decision and may account for more than 80 % of the return of the portfolio.

Each asset class will generally have different levels of return and risk. They also behave differently. At the time one asset is increasing in value, another may be decreasing or not increasing as much and vice versa. The measure used for this phenomenon is called the correlation coefficient.

Some practical allocation examples: Click here

PORTFOLIO MANAGEMENT

The portfolio theory was originated by Markowitz in the early 1950's. and further developed in the 1960's by Sharpe. 

Based on the principle "Don’t put all your eggs in one basket.", the investors knew intuitively that it was smart to diversify their portfolio. Markowitz was  the first to quantify risk and demonstrate quantitatively why and how portfolio diversification works to reduce risk and optimize return for investors.

Markowitz has also introduced the concept of an "efficient portfolio". An efficient portfolio is one which has the smallest attainable portfolio risk for a given level of expected return (or the largest expected return for a given level of risk).

The theory of Markowitz, known as CAPM (Capital Asset Pricing Model), will be introduced in the next sections.