Investment Analysis and Management

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Create a portfolio comprising a collection of three asset classes (two traditional assets, namely stocks and bonds) and one alternative asset class (any one of your choice) taking into consideration risk-return and modern portfolio theory.

You are expected to explain the rationale behind your portfolio selections, and more importantly explain why the portfolio you have constructed using these assets is a robust, well constructed, efficient portfolio in line with the discussion on the subject in class and material covered.

Sample Solution

 

 

 

This sample portfolio incorporates two traditional asset classes (stocks and bonds) and one alternative asset class (real estate investment trust – REIT) following principles of modern portfolio theory (MPT). MPT emphasizes diversification to achieve optimal risk-adjusted returns.

Asset Allocation:

  • 50% – U.S. Large-Cap Stocks: This provides exposure to established companies with a history of stable growth and dividend payouts. They offer high potential returns but also carry higher risk.
  • 30% – Investment-Grade Corporate Bonds: These bonds offer steady income and lower volatility compared to stocks. They act as a hedge against market downturns.

 

 

  • 20% – REITs: REITs invest in income-producing real estate. They offer diversification, potential for capital appreciation, and dividend income.

Rationale for Selection:

  • Risk-Return Tradeoff: This allocation balances risk and return. Large-cap stocks have the potential for high returns but also higher risk. Bonds offer lower risk and lower returns, providing stability. REITs offer a middle ground with some risk and potential for higher returns than bonds.
  • Diversification: The portfolio is diversified across different asset classes with varying risk-return profiles. This helps reduce overall portfolio volatility.
  • Negative Correlation: Ideally, chosen assets have a negative correlation, meaning when one asset class experiences a decline, another might experience an increase. This helps mitigate losses. While not perfectly negatively correlated, stocks and bonds often exhibit this tendency. REITs can add further diversification as their performance might not directly mirror stocks or bonds.

Benefits of this Portfolio Construction:

  • Potential for Growth: The large-cap stock allocation offers the potential for capital appreciation over the long term.
  • Income Generation: Bonds and REITs provide a steady stream of income through dividends or interest payments.
  • Reduced Volatility: Diversification across asset classes helps mitigate portfolio volatility and reduces the risk of significant losses.

Considerations and Customization:

This is a sample portfolio, and the ideal allocation will vary depending on individual circumstances. Factors to consider include:

  • Risk Tolerance: Investors with a higher risk tolerance can allocate a larger portion to stocks. Conversely, risk-averse investors may increase their bond allocation.
  • Investment Time Horizon: Younger investors with a longer time horizon can handle more risk. As investors approach retirement, the portfolio might shift towards a more conservative allocation with higher bond weightings.
  • Financial Goals: The portfolio should be aligned with individual financial goals. For example, someone saving for retirement might prioritize long-term growth, while someone saving for a down payment might prioritize short-term liquidity.

Conclusion:

This portfolio construction emphasizes diversification and risk management while offering the potential for growth and income generation. By following MPT principles, this sample portfolio aims to be robust and well-constructed, but remember, it’s always wise to consult a financial advisor for personalized investment strategies.

 

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