Over the years the problem of asset allocation has been on the increase, this is to say that

potential investors continually find it difficult to distribute their wealth for investment
purposes. Therefore this essay is going to critically evaluate the various investment strategies
and techniques that can be used to solve the problem of asset allocation for an investor.

Asset allocation can be defined as an investment portfolio technique that aims to balance risk
and create diversification by dividing assets among major categories such as cash, bonds,
stocks, real estate and derivatives. (See www.investopedia. com)

However, before an asset can be allocated the first thing that is done when an investor comes
to an investment adviser or manager is to prepare a policy statement. A policy statement
serves as blueprint for building a winning portfolio and it is important for the long term
achievement of the investor’s specific goals. The policy statement helps you to learn more
about what your needs and priorities are and how best the needs can be addressed and the
various risks involved with investing. It also helps the manager on how best to manage your
portfolio to accomplish your specific financial goals. A properly drawn up policy statement
contains your investment objectives, constraint, issues related to your risk tolerance (risk
profile), how the asset would be allocated, how the portfolio would be monitored
(benchmark), the rebalancing process and the agreement between the investor and the
manager so has to make it easy for another manager to take over if the initial manager should
leave.

Risk tolerance is your ability and willingness to lose some or all of your original investment
in exchange for greater potential returns it is the key driver that determines your asset
allocation plan. Those important factors are age, lifestyle, current income, marital status. For
example an individual earning high income has a bigger tendency to accept risk because his
income can help in recovering from any loss. Likewise, individuals that are young can afford
to invest in risky investments because they have a long time to recover from the loss.

However when the asset allocation is not associated to your risk profile it becomes difficult
to plan for your goals accurately because if you don’t have an idea of the return you could
generate from your portfolio, which is closely connected to the risk level of your portfolio,
then planning is difficult. There is also a possibility of abandoning your plan because lack of
understanding of the risks involved in your portfolio can make you reactively adjust your
portfolio based on market activity rather than proactively creating a plan and sticking with it.
Therefore to be a successful investor who sticks with your plan through the market’s ups and
downs, you need an understanding of how your portfolio might perform and you also need to
note that your risk profile changes as you grow older and as your lifestyle changes.

In addition, you have to set a benchmark that is a standard that can be used to compare the
performance of your portfolio For example; the Nasdaq may be used as a benchmark against
which the performance of a technology stock is compared. The choice of the benchmark
generally depends on your preferences for example Very unadventurous investors (risk
adverse) tend to choose a fixed-income investment alternative, while more aggressive
investors (risk takers) tend toward a market index.

There are three major classes in which asset can be allocated and they are stocks, bonds and
cash. Stock can also be called share or equity and it can defined as a share in the ownership of
a business but it has the greatest risk and highest returns among the three major asset
categories. There are two main types of stocks and they are common stocks and preferred
stocks. Common stock gives more returns through capital growth when compared to other
forms of investment and this is because it requires more risk for example If a company goes
bankrupt and liquidates, the common shareholders will not receive money until the creditors,
bondholders and preferred shareholders are paid.

Bond is a way of lending the issuer of the bond money an amount that will be paid back. The
benefit of holding a bond is that it a safer alternative of investing in shares. Whereas the
disadvantage of owning a bond is that it provides lower returns when compared to other
forms of asset categories. You should keep in mind that certain categories of bonds offer high
returns similar to stock and these bonds are known as high-yield or junk bonds which also
carry higher risk. There are various types of bonds and they are income bonds, debentures,
mortgage bonds, collateral bonds and convertible bonds. (See www.morningstar.com)

Cash such as savings deposits, certificates of deposit, treasury bills, money market deposit
accounts, and money market funds are the safest investments, but offer the lowest return of
the three major asset categories. Therefore in other to choose between the three categories in
which asset can be allocated an analysis has to be carried out and the analysis can be done in
two ways which are fundamental or technical. Fundamental analysis involves analyzing the
features of a company in order to assess its value. This is done by studying the economic,
financial and other qualitative and quantitative factors that can affect the business. It uses
return on equity, asset turnover, earnings per share, current ratio, return on capital, interest
rate and other data to assess the stocks and bonds whereas, technical analysis entails
analyzing statistics caused by market movement, like past prices and volume. Technical
analysts do not attempt to measure a security's intrinsic value, but instead use charts and other
tools to identify patterns that can suggest future activity.

However before you decide the method of analysis you want to use it is important that we
weigh the pros and cons of both analyses. The benefits of using fundamental analysis is that it
try to work out what the company worth that is putting value on the company. But the
drawbacks is that it takes time and at times it can be difficult to get data which can be risky
for the investment because before you finish working out the value someone else may have
bought the share. It makes use of historical data which can be unsafe for predicting the future.
At the same time the benefits of using technical analysis is that it makes it easy and faster to
measure market reaction by taking look at the recently traded volume with the use intraday
charting and other volume indicators. It also good for tracking reactions overtime for
example if you take a look at the charts of various housing stocks, you'll often see that they
react negatively when the Federal Reserve chooses to forgo a cut in interest rates. Or check
out how home improvement stores tend to react when reports of new and existing home sales
decline. The reactive move is in most cases consistent each time. But the limits of technical
analysis are that Charts don't usually or always forecast macro trends because most times
charts are generally unable to accurately forecast macroeconomic trends. For example, it is
nearly impossible to look at a key player in the oil and gas sector and interpret whether OPEC
intends to increase the amount of oil it pumps. Another thing you have to note is that reading
of chart makes use of subjectivity because different people see different things on the chart
while some see the chart and feel that a stock is rising and another person sees it and feels
that the stock is falling. (See www.investopedia.com)

Furthermore, since you now know the various ways that can be used for allocating the stocks
and bonds for your portfolio there is need to analyse the various risks and strategies that can
be use to manage the portfolio. Firstly the various risks you could come across in the
process of allocating your asset are financial risk which occurs when a company whose stock
you purchase loses money. This type of risk takes place when companies liquidate or goes
bankrupt and are mostly suffered by common stock holders.

Interest rate risk is a risk that exists due to changes that occurs in the interest rates. For
example if you buy a long term high quality bond and get a yield of six percent since it is a
bond you will consider your money safe but after investing the interest rate increases to eight
percent then you will be faced with the problem that your six percent bond is likely to drop in
value because interest rate rose.

Market risk occurs as a result of supply and demand since no matter how modern the society
and economic system is you can’t escape the laws of supply and demand because when
masses of people buy a particular stock it becomes a demand and if the supply is limited the
prices will rise higher whereas if no one is interested in buying the stock its price will fall.
This shows that the price of the stock you purchase can rise and fall unexpectedly due to
market demand.

Exchange rate risk is a risk that occurs as a result of investing in different countries that has
different currencies.

Inflation risk is the artificial expansion of the quantity of money so that too much money is
used in exchange for goods and services that is your money does not buy what it used to. This
risk means that the value of your investment may not keep up with inflation for example if
you have money in a bank saving account that is earning four percent the account is flexible
therefore if the market interest rate goes up the rate you earn in your will also go up therefore
making safe from financial and interest rate risk but open to inflation risk if the inflation rate
is five percent because you will be losing money.

Tax risk can affect the amount of money you get to keep because the main reason for
investing is to increase your wealth therefore you need to understand that tax can take away a
portion of the wealth you are trying to put together . It is risky when you make a wrong
decision with your stocks like selling them at a wrong time because you can end up paying
higher tax than you need to. This is due to the fact that tax law change frequently.

Political and governmental risk can affect the value of your stock in the sense that a new
regulation or law is enough to send a company bankrupt as well as increase the sale and profit
of another company for example tobacco companies were the political targets which weaken
their stock prices.

Personal risks are those factors that are not directly related to investment that affect the stock
price. It is a risk that occurs in relation to your circumstance for example if you experience a
financial difficulty like losing your job you will need quick cash which means you may have
to sell your stock to get money. It often occurs to investors who don’t have an emergency
fund.
However, in order to avoid the above risks there are diverse strategies that can be adopted in
managing your portfolio and they are called the asset allocation strategy and the bond
allocation strategies however, both strategies comprises of various underlying strategies
which shall be discussed has follows. Firstly the asset allocation strategy can be divided into
two major strategy which is the active management and passive management strategy.

Active management strategy is a way of picking attractive stocks, bonds, mutual funds that
will add value that will do better than your benchmark. The strategy also has to with been
able to decide when to move into and out of the market, place leveraged bets on the future
direction of securities and markets with options, futures and derivatives. The objective of this
strategy to make profit better than the market that is the strategy is against the efficient
market hypothesis because it argues that you can beat the market by picking the right stock
and spotting increases early. It makes use of different strategies to achieve the objectives
which are fundamental strategies that have to do with the three step approach that is they look
at the country, industry and the company and screen it based on the various stock
characteristics which are value, growth, P/E, capitalization, and sensitivity to economic
variables. It also position a portfolio to take advantage of the market’s next move by splitting
between stocks and bonds, shifting between different sectors and investment

Another strategies used for the active management strategies is the technical strategy and it
entails Contrarian investment strategy which has to do with buying at a low price and selling
at a high price and re- investing the returns, price momentum strategy and earnings
momentum strategy. The active strategy, enables you has an investor to adjust your asset mix
from your long term asset mix depending on your views of the markets. If you believe that
stocks are going to outperform in the short term, then you can overweight the equity asset
class in your portfolio. For each asset class, individual securities would be purchased, with
the belief that you can beat your benchmark. This strategy is appropriate for investors that are
risk lovers and believe that they have superior stock picking skills.

Passive management strategy is strategy that does not endeavour to differentiate attractive
from unattractive securities, or forecast securities prices, or time markets and market sectors.
It has to do with investing in broad sectors of the market, called asset classes or indexes
although the aim is to make profit, but it is through accepting the average returns various
asset classes produce. That is the method believe the efficient market hypothesis that the
market cannot be beaten instead, it allocate assets based upon empirical research, probable
asset class risks, returns and by diversifying widely within and across asset classes, and by
maintaining allocations for long-term through periodic rebalancing of asset classes.

However there are various strategies used to achieve these goals and they are Index Portfolio
Strategy Construction Techniques that can be divided into three parts which are full
replication that is all securities in the index are purchased in proportion to weights in the
benchmark index but the benefits of these method is it enables close tracking of the portfolio
whereas the disadvantage is that it increases transaction costs, particularly with dividend
reinvestment.

Sampling as to with buying a representative sample of stocks in the benchmark index

according to their weights in the index. The advantage of this method is that it makes it easy
to reinvest your dividend and the disadvantage is that it can lead to low commission due to
the fewer stocks; it might also lead to tracking error because it will not track the index
closely.

Quadratic optimization or programming makes use of historical information on price changes

and correlations between securities by imputing it into a computer program so as to determine
the composition of a portfolio that will minimize tracking error with the benchmark the
advantage of these method is that it is easy to do and faster while the disadvantage is that it
relies on historical correlations, which may change over time, leading to failure to track the
index.

Another method employed by the passive management strategy is the index portfolio
investing which is a form of investing in which portfolios are based upon securities indexes
which sample various market sectors for example the Dow Jones Industrial index, which is a
basket of thirty very large U.S. companies. This method can be divided into two which are
Index Funds which is a form of making full replication of a benchmark index and Exchange-
Traded Funds (ETFs) which are depository receipts that give investors a pro rata claim on the
capital gains and cash flows of the securities that are held in deposit by a financial institution
that issued the certificates. Examples of ETFs that can be used for managing risk are
derivatives.

Derivative can be defined as financial contracts whose value is derived from, or related with,
the value of other assets, interest or exchange rates, or indexes. Derivatives instruments can
be divided into the basic building blocks of options, forward contracts, futures and swap.
Options gives you the right to sell (put option) or buy (call option) something in the future at
a price determined at the onset. It is a way of protecting the gains you made in your portfolio
and also guarantees a minimum level at which you could sell the shares in the future without
you limiting any gains you might have made. Options have a set of contracts that are known
as Caps and floors.

Caps pay off when prices move above a threshold value known as the cap’s “strike price” or
“exercise price,” where the payoff reflects the difference between the market price and the
strike but only if the market price is higher than the strike. Similarly, floors pay off when the
market price moves below floor strike price, where the payoff reflects the difference between
the two but only if the market price is below the strike. However, the former serves as a price
fixing mechanism, while the later works more like insurance that compensates you when the
risk you are hedging is realized.

Futures and forward is a way of buying or selling an underlying asset at the same time in the
future but the disadvantage is that you cannot let the contract lapse however the difference
between the both of them is that forward contracts are bilateral agreements that has no active
secondary markets while futures are traded in exchanges and has a active markets. The
benefits of owning a future contract is that it entails lesser risk because market participants
post a performance bond called margin. Another benefit of both contracts is that the
exchanges that is market deals with the risk. For example if your future increases in value the
gain is added to your margin equally if you looses the value is deducted from your margin.

A swap involves two parties who agree that for a certain period they will exchange regular
payments according to a contract. What they are exchanging is a forward obligation. Swap
can be in two forms which are interest rate swap and exchange rate swap. Example is when
one party exchanges fixed rate interest payment for the others party’s floating rate interest
payment.

In addition , you have to know that forward-type derivatives (inclusive of futures contracts
and swap contracts) gain if the market moves in one direction, and lose in the other direction;
and the magnitude of the gain or loss will be equal with extent of the market move of the
underlying price (or interest rate or exchange rate).

Also the benefits of using derivatives are that it allows instant diversification over a whole
market index or sector, by spreading risk and increasing access to range of securities. It can
be easily traded and continually priced throughout the working day like shares. It requires no
set fee and increases the market efficiency for the underlying asset. While the disadvantage is
that the structure of regulation is badly organized to deal with the fast growing derivative
markets and there are also many disagreements among regulators on how to handle
systematic risk.

Furthermore there various ways in which bond portfolio management could be used for
managing risk and they are passive portfolio strategies which entails buy and hold that is
trading into more desirable positions and indexing which as to do with matching performance
of a selected bond index these can be done by examining tracking error. The advantage is that
it enables you to see the historical performance of your managers.

Another strategy for managing bond portfolio is the active management strategies that
includes Interest rate expectations strategy which has to do with been able to accurately
forecast future level of interest rates and by adjusting the portfolio duration through the use of
swaps or by exchanging bonds in portfolio for new bonds to achieve target duration and
interest rate futures. It also include Valuation analysis that is the Identification of securities
that are not valued appropriately, Credit analysis that is seeking to find out changes in the
default risk, yield spread analysis that is trying to check the spread in yield between a safe
and junk bond in other to take advantage of any abnormalities in the market, core-plus
management strategy is you combine active and passive strategies within your portfolio. For
example, a Canadian investor might buy individual securities for the Canadian part of their
portfolio and then purchase ETFs for exposure to the U.S. and global stock markets. While
the last strategy used by the active management strategies is bond swaps (Swaps and futures
have been explained above).

Also, the matched funding techniques and the immunization strategies are used under the
active management strategies. The matched funding techniques comprises of the dedicated
portfolio that is a prescribed set of portfolio used to service a specific liability, exact cash
match that is a portfolio with no reinvestment policy, Optimal match with reinvestment, and
horizon matching that is the combination of immunization strategy and dedicated portfolio.
Whereas the immunization strategy is about managing the maturity day of the bond with the
interest rate to protect against rate changes for example pension fund and insurance company
the rate of return is fixed. While contingent immunization is when you provide flexibility for
the manager to pursue an active strategy that is your rate of return is flexible.
The advantage of pursuing an active management strategy is that they are good at following
the market's trends closely and reacting quickly to changing conditions. It allows you to take
advantage of periods when small cap stocks, for example, out-perform large cap stocks or
vice-versa and it also yields higher average returns. They can significantly boost returns over
time by quickly reacting to changing market conditions for various asset classes and sectors
by capturing periods of over-performance and avoiding periods of under-performance. But
the disadvantage is that it is expensive due to market, management cost and it is very risky.

The advantages of pursuing passive management is that passively constructed portfolios are
highly diversified and contain thousands of securities allocated amongst various investment
categories which makes the risk and returns predictable and quantifiable. It is also very safe
and less risky. While the disadvantage is that during the life cycle of the portfolio, certain
assets in the allocation will underperform which leads to inefficiency. It doesn’t take the
market conditions of any asset class into account and it presents the investor with a difficult
tradeoff of reducing long term returns in order to minimize short-term risk.

Conclusions

In conclusion, the strategy you adopt in managing your portfolio depends on your age,
lifestyle and skills. If you believe you can outperform (risk lover) the market then it might be
best you adopt an active portfolio. If however you believe that you cannot outperform or add
value then it will be preferable you adopt a passive portfolio (risk adverse). However you
might adopt both strategies to manage your portfolio if you a risk neutral person and not too
old. Therefore it will be better if you concentrate on those areas of your portfolio where you
can add the most value, and still get proper diversification in the other part of your portfolio
by using low cost ETFs.