Page 254 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 9: Portfolio Management

9.5 Building an Investment Portfolio Notes

We now consider how investors go about selecting stocks to be held in portfolios. Individual
investors often consider the investment decision as consisting of two steps:

1. Asset allocation
2. Security selection
The asset allocation decision refers to the allocation of portfolio assets to broad asset markets; in
other words, how much of the portfolio's funds are to be invested in stocks, how much in bonds,
money market assets, and so forth. Each weight can range from 0% to 100%. Examining the asset
allocation decision globally leads us to ask the following questions:
1. What percentage of portfolio funds is to be invested in each of the countries for which
financial markets are available to investors?
2. Within each country, what percentage of portfolio funds is to be invested in stocks, bonds,
bills, and other assets?

3. Within each of the major asset classes, what percentage of portfolio funds is to go to
various types of bonds, exchange-listed stocks versus over-the-counter stocks, and so
forth?

Many knowledgeable market observers agree that the asset allocation decision may be the most
important decision made by an investor. According to some studies, for example, the asset
allocation decision accounts for more than 90% of the variance in quarterly returns for a typical
large pension fund.

According to some analyses, asset allocation is closely related to the age of an investor. This
involves the so-called life-cycle theory of asset allocation. This makes intuitive sense because
the needs and financial positions of workers in their fifties should differ, on average, from those
who are starting out in their twenties. According to the life-cycle theory, for example, as
individuals approach retirement they become more risk averse.
Asset Classes

Portfolio construction begins with the basic building blocks of asset classes, which are the
following major categories of investments:
1. Cash (or cash equivalents such as money market funds)

2. Stocks
3. Bonds
4. Real Estate (including real estate investment trusts)
5. Foreign Securities

!
Caution Each investor must determine which of these major categories of investments is
suitable for him/her. The next step, as discussed in the preceding section on asset allocation,
is to determine which percentage of total investable assets should be allocated to each
category deemed appropriate. Only then should individual securities be considered within
each asset class.

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