- Asset Allocation
- Security Selection
Also asset allocation is closely related with the age of investor this is called Lif-Cycle theory. The investor with age of 50 nearing to retirement should take very little risk for his investments and the person who is just starting his carrer can take high risk because he has time on his hand. So ideally younger the investor more allocation to stocks and older the investor less allocation to stocks.
List out the asset classes
1) Cash or savings account
4) Real Estate
5) Foreign Securities
Financial planner in consultation with the investor should plan out percentages to be allocated to each of the assets. The next step would be about individual securities within each asset class.
Average portfolio risk can be reduced by 19% as we keep on adding securities to the portfolio the total risk associated with the portfolio of stocks declines rapidly. The first few stocks cause a large decrease in portfolio risk. based on actual data 51 percent of the portfolio standard deviation is eliminated as we go from 1 to 10 securities. unfortunately the benefits of adding more securities after a point is very small and it keeps getting smaller and smaller.
Modern portfolio theory according to Markowitz.
Markowitz developed an equation that calculates the risk of a portfolio as measured by the variance or standard deviation. His equation accounts for two factors.
1) Weighted Individual Security risks that is variance of each individual security, weighted by percentage of investible funds placed in each individual security.
2) Weighted co-movements between securities returns that is the covariance between the securities returns, again weighted by the percentage of investible funds placed in each security.