[MUSIC] Learning Outcomes, after finishing this video and be able to understand what's strategic asset allocation means. Understand the relation between correlation and asset allocation. Explain what Asset correlation matrix means. Know the pitfalls of modern portfolio theory. [MUSIC] We've been introduced to several investment philosophies so far. We started with index investment that aims to generate returns from the market, to bidder. This pass of investing style means you invest in a board market index. And as we saw empirical evidence that shown that this strategy has consistently beaten the returns of actively manager's funds in the long run in Agrivet. Then we move to the other extreme, active investment. In the world of hedge funds and alternative assets. We will touch upon how institutional investors generate returns over very long run by investing in these alternative assets. One key thread runs through all the philosophies that we have looked at. Returns are dependent on the assets one invests, heavily dependent. The profile of the assets, the risk, the quality and, of course, the time horizon of the investment. Where to allocate investable capital is the crucial decision one has to make. Indeed, this is the acid allegation and is the single most important and ought to be the most time consuming part of any investment framework. It's not about the right stock or timing the market by a favored manager. Rather, exceptional returns are created by how an investor allocates capital to various asset classes. How do they choose an optimal asset mix, that generates superior risk-adjusted returns given his risk appetite? We will look into these issues in this model. I want to stop here and bring your attention to this graph. This graph is a well known graph that clarifies the importance of asset allocation. What it tells you is 90% or more of any portfolio's return is determined by what we call strategic asset allocation or the long term asset allocation. Timing and security selection are small components of what a portfolio ultimately returns. This is why asset allocation is the single most important decision that all investors must make. Let's move on by discussing the determinants of portfolio performance. Before the allocation decision is made, you need to come up with a strategic asset allocation. The strategic asset allocation decision pivots around a number of factors that we will now discuss. The primary among these are of course the investor's goals, risk tolerance and time horizon. The risk-return trade-offs the investor is willing to make. And then of course the market characteristics of the underlying assets, he correlations and the return potential. And finally, we will discuss the need to rebalance any portfolio on an ongoing basis. If you are investing through a fund sort of indirectly. You also, of course, need to figure out the skill of the asset manager. You need to figure out fund fees and all of these other constraints that we talked about the last time. On the very first things one has to do is, you got to figure out what the goal is. What their goals are. This one important decision of quantifying the financial goal, sets the stage for the further actions that need to be taken. On the one hand, you may have investors who are saving for retirement. On the other hand, you may have institutions such as other well funds or saving for generations. A financial goal one has in mind should be realistic, achievable. Once this important step has been taken care of, the next step is to figure out the risk appetite of the investor. How much risk one is willing to take dramatically the asset allocation decision. Theoretically, the aim is to maximize return for a given level of risk tolerance. If one has a higher tolerance for risk, you can take If you invest in asset classes which have high risk profiles. But you must be able to be willing to tolerate the draw-downs that necessarily occur when you go to high risk investments. And then importantly, we'll spend quite a bit of time on this, is the time horizon effects the asset allocation decision. Assets produced different returns for different time horizons. If your time horizons are short, you cannot afford a lot of market to market fluctuations. Volatility will affect realize returns. In these cases, you don't want to have too much allocation the equity and now the risky asset classes. Because it will already will affect your returns if you have to take it out prematurely. And so, the short time horizon portfolios tend to be rated much more heavily towards fixed income like assets. If the investment horizon is long, however, you can take a lot more risk and portfolios tend towards large equity asset allocation. A long horizon portfolio can stomach the volatility because in the long haul there is mean aversion and market to market risk tends to be smoothed out. Equity is the most powerful overall asset, overall asset classes. As we've seen before even in index, equity index forms extraordinarily well. And so, most long horizon investors, have large equity asset allocations. Equity allocations will only have good returns, but they also tend to have decent inflation hedging properties. But only over the long run, in the short run inflation can affect equities too. Equity heavy portfolios have had large positive real returns and returns even after tax after inflation. For example, since 1970 the average US inflation has been 4.18% while the S&P has given them an average return of 11.6%. So even once you take out inflation, returns of the S&P have been very attractive. This is not true of fixed income. Let's examine strategic ASTRA allocation a little more. Consider the following scenario, a $100 investor in the S&P 500 in 1970 would have grown to 770,000, $7,770 by the end of 2003. By the same amount invested in commodities would have yielded $4,830. But a weighted investment in the two would have generated 9,450. You can see this in this graph, it's a smolder return. Underlying the naive diverse switching strategy, is a cornerstone of modern finance and modern portfolio theory. Modern portfolio theory basically suggests that an investment should be seen as a part of many and is just part of a diversified portfolio. Any incremental investment will seek to improve the risk return trade-off of the portfolio as a whole thereby providing a superior risk adjusted return. A diversified portfolio, like the one we considered above can deliver better than the sum of it's parts in the long run, because it tends to smooth out returns. As it's frequently said, diversification is the only free branch in all of finance. This diversification is made possible by the fact that rarely do two assets move in perfect lockstep with each other. Adverse events may effect one security but not the other. If one is able to diversify into assets with little or no correlation, then the overall risk of this portfolio could be lowered. If such an investment is made in indices or large asset classes, then there is very little systematic or firm-specific or security-specific risk. And it's only the systemic risk, that comes through. And therefore, well-diversified portfolios tend to have lower risk, lower volatility and intend to recover faster from adverse shocks. [MUSIC]
