Reading 18: Asset allocation

1. Specifying risk and return objectives

– The return objective for an individual’s or institution’s portfolio is based upon the size of the portfolio, long-term spending (liquidity) needs, the time horizon, and the maintenance of the principal.

– Investors can be placed into numerical categories of risk aversion using a rough approximation or through answers to questionnaires.

We can determine the utility – adjusted return the investor will realize from the portfolio:


Utility – adjusted return

utility adjusted return


2. Downside risk

– In addition to standard deviation as measure of risk (volatility), the acceptable level of risk can be stated in terms of downside risk measures such as short fall risk, semivariance, and target semivariance.

– Shortfall risk is the risk of exceeding a maximum acceptable dollar loss.

– Semi variance is the bottom half of the variance (the variance calculated using only the returns below the expected return).

– Target semi- variance is the semi-variance using some target minimum return, such as zero.


Roy’s Safety- First Measure is one of the oldest and most cited measures of downside risk:



3. Specifying asset classes

Asset classes are appropriately specified if:

– Assets are similar from a descriptive and statistical perspective.

– They are not highly correlated so they provide the desired diversification.

– Individual assets can not be classified into more than one class.

– They cover the majority of all possible investable assets.

– They contain a sufficiently large percentage of liquid assets.