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The asset allocation decision involves dividing investments among different asset classes like stocks, bonds, and cash. The optimal allocation depends on an individual's risk tolerance, time horizon, and ability to withstand risk. Risk tolerance refers to how much investment loss one is willing to accept, while time horizon is the number of years until one's financial goal. There are various ways to manage risk, such as diversifying investments to reduce risk, transferring risk to a third party through insurance, or avoiding risk altogether. The expected return of an investment is the probability-weighted average of possible returns, while the risk premium means risky investments should provide higher returns to compensate for potential losses.

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17 views4 pages

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The asset allocation decision involves dividing investments among different asset classes like stocks, bonds, and cash. The optimal allocation depends on an individual's risk tolerance, time horizon, and ability to withstand risk. Risk tolerance refers to how much investment loss one is willing to accept, while time horizon is the number of years until one's financial goal. There are various ways to manage risk, such as diversifying investments to reduce risk, transferring risk to a third party through insurance, or avoiding risk altogether. The expected return of an investment is the probability-weighted average of possible returns, while the risk premium means risky investments should provide higher returns to compensate for potential losses.

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Alexandra Denise Peralta
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THE ASSET ALLOCATION DECISION

Asset Allocation
- Asset allocation involves dividing your investments among different assets, such as
stocks, bonds, and cash. The asset allocation decision is a personal one. The allocation
that works best for you changes at different times in your life, depending on how long
you have to invest and your ability to tolerate risk.

Factors to consider include your:


● Risk. is defined in financial terms as the chance that an outcome or investment's actual
gains will differ from an expected outcome or return. Risk includes the possibility of
losing some or all of an original investment.
○ Business risk - the risk that the company will have general business problems.
This type of risk is mainly dependent upon changes in demand, input prices and
technological obsolescence.
○ Liquidity risk - this risk arises from the possibility of an asset that may not be
sold for its market value, given a short notice. It is said to have a good amount of
liquidity risk if an investment must be sold at a high discount.
○ Default risk - this is the risk that the issuing company is unable to make periodic
interest payments or principal repayments on debts. Example: Bonds,
debentures and other long-term debts.
○ Market risk - this is the risk of changes in stock prices in the market, described
by volatility and affected by bullish and bearish trends.
○ Interest rate risk - this is the risk of fluctuations in the value of an asset as the
interest rates change. If interest rates rise, the price of fixed income securities
like debentures fall and vice versa.
○ Purchasing power risk - this risk is the possibility of receiving a lesser amount
of purchasing power than was originally invested.
● Risk Tolerance. Risk tolerance is your ability and willingness to lose some or all of your
original investment in exchange for potentially greater returns.
● Time Horizon. Your time horizon is the number of months, years, or decades you need
to invest to achieve your financial goal. Investors with a longer time horizon may feel
comfortable taking on riskier or more volatile investments. Those with a shorter time
horizon may prefer to take on less risk.
Methods of Handling Risk

● Risk avoidance: elimination of activities that can expose the individual to risk; for
example, an individual can avoid credit/debt financing risk by avoiding the usage of
credit to make purchases.
● Risk reduction: mitigating potential losses or the severity of potential losses; for
example, an individual can diversify their investment portfolio to reduce the risk that their
investment portfolio experiences a severe negative drawdown.
● Risk transfer: the process of transferring risk to a third party; for example, an individual
may purchase a life insurance policy to offload the risk of premature death to the insurer.
● Risk retention: the process of accepting responsibility for a particular risk, for example,
an individual deliberately not insuring their property

What Is a Risk Premium?


- The risk premium refers to the concept that, all else being equal, greater risk is
accompanied by greater returns. This is an important concept for financial managers
hoping to borrow money. Lenders will look closely at a company to determine how risky
they believe the company is and will base their decision to lend to that company on that
level of risk.
- Think of risk premium as a form of hazard pay for your investments. An employee
assigned dangerous work expects to receive hazard pay in compensation for the risks
they undertake. It's similar to risky investments. A risky investment must provide the
potential for larger returns to compensate an investor for the risk of losing some or all of
their capital.

What Is Interest Rate Risk?


- Interest rate risk is the danger that the value of a bond or other fixed-income investment
will suffer as the result of a change in interest rates.
- If interest rates rise, the price of fixed-income securities like debentures fall and vice
versa .

Elements of Risks

Unsystematic risk is the risk that is unique to a specific company or industry. The returns of a
company may vary due to certain factors that affect only that company.
Systematic risk refers to the risk inherent to the entire market or market segment. These
changes affect all organizations to varying degrees.

Risk Concepts

● If an outcome is known with certainty, such as the value of a treasury bill at maturity, it is
considered riskless.
● On the other hand, if an investment has a potential for loss, it would be considered risky.
● Hence, risk can be defined as a measure of the uncertainty in a set of potential
outcomes for an event in which there is a chance of some loss.
● In statistics, measures of dispersion such as variance and standard deviation can help
determine how spread out investment outcomes are around their mean or average
value. The larger the standard deviation, the greater is the variability and hence the
riskiness of the set of values.

Standard deviation = √Probability(Given or Historical Rate of Return - Expected Rate of Return)²


* 100

Concept of Return

Return can be defined as the actual income from a project as well as


appreciation in the value of capital.
In connection with return we use two terms – realized return and expected or predicted return.
Realized return is the return that was earned by the firm, so it is historic.

Realized rate of return = (Initial investment - Carrying amount of investment) / Initial investment
* 100

What Is the Expected Rate of Return?

The expected rate of return is a percentage return expected to be earned


by an investor during a set period of time.

Expected Rate of Return = P1 * R1 + …. + Pn * Rn * 100

In this formula, P is the probability of that return, R is the rate of return in a given scenario and n
is the number of scenarios an investor may consider.

Return A:
0.45*0.15+0.4*0.08+0.15*-0.11 = 0.083= 8.3%
Return B:
0.45*0.16+0.4*0.09+0.15*-0.13 = 0.0885= 8.85%

Important note:
The expected return is not absolute, as it is a projection and not a realized return.
References

https://www.sofi.com/learn/content/how-to-calculate-expected-rate-of-return/

https://www.investopedia.com/terms/i/interestraterisk.asp

https://www.investopedia.com/terms/r/riskpremium.asp

https://corporatefinanceinstitute.com/resources/career-map/sell-side/risk-management/financial-
risk-management-strategies/

https://www.investopedia.com/terms/r/risk.asp

https://www.investor.gov/introduction-investing/getting-started/asset-allocation

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