Asset allocation

As an investor, you, most probably, have two objectives: 1) you want to make a lot of money quickly and 2) you do not want to risk losing the capital you invest. However, these objectives are irreconcilable: you can achieve one or the other, but not both at the same time.

For example, you actually have a chance of making a lot of money quickly by investing in an Internet start-up, but at the same time there is high probability that you might loose much if not all of your invested capital by doing so.

Or, in another extreme, you can invest in your country's government bond denominated in local currency and stay virtually assured that you will get your invested capital back with the promised interest upon the bond's maturity, as governments can print money and satisfy practically unlimited amount of its debt obligations in such a way. Never mind that that capital you invested in this manner will most likely loose in its purchasing power due to inflation - nominally, it will grow.

Each of these extremes could be appealing even to a rational investor, but only in very specific circumstances. Most investors try to balance the expected return on their investments with the level of risk of loosing money in the process of achieving this return. Quite often this is done by diversification of investments across different investment classes that besides having different risk-return characteristics also have an additional useful quality of not being exactly correlated with each other. This is where the concept of asset allocation comes into play.

We define asset allocation as an algorithm of splitting investable capital among investment classes with the purpose of achieving highest investment return at a given level of risk, based on individual circumstances and goals on each investor.

Of course, if you know of a sure bet that will pay handsomely higher than the government bond of the corresponding maturity - by all means, take it. Please make certain, though, that it is indeed a sure (i.e. riskless) bet, as in real life such opportunities are extremely rare.

In the absence of riskless bets, you might want to devise an investment strategy that will govern your investment decisions - without one you will be like a boat without a rudder in a stormy sea. Inevitably, in devising such a strategy you will come across assets allocation. We will cover this topic in mode detail in subsequent chapters.

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VALUATION THEORY       ASSET ALLOCATION

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