Capital Allocation Between The Risky Asset And The Riskfree Asset

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Portfolio managers seek to achieve the best possible trade-off between risk and return. A top-down analysis of their strategies starts with the broadest choices concerning the makeup of the portfolio. For example, the capital allocation decision is the choice of the proportion of the overall portfolio to place in safe but low-return money market securities versus risky but higher-return securities like stocks. The choice of the fraction of funds apportioned to risky investments is the first part of the investor's asset allocation decision, which describes the distribution of risky investments across broad asset classes—stocks, bonds, real estate, foreign assets, and so on. Finally, the security selection decision describes the choice of which particular securities to hold within each asset class. The top-down analysis of portfolio construction has much to recommend it. Most institutional investors follow a top-down approach. Capital allocation and asset allocation decisions will be made at a high organizational level, with the choice of the specific securities to hold within each asset class delegated to particular portfolio managers. Individual investors typically follow a less-structured approach to money management, but they also typically give priority to broader allocation issues. For example, an individual's first decision is usually how much

of his or her wealth must be left in a safe bank or money market account. This chapter treats the broadest part of the asset allocation decision, capital allocation between risk-free assets versus the risky portion of the portfolio. We will take the composition of the risky portfolio as given and refer to it as "the" risky asset. In Chapter 8 we will examine how the composition of the risky portfolio may best be determined. For now, however, we start our "top-down journey" by asking how an investor decides how much to invest in the risky versus the risk-free asset. This capital allocation problem may be solved in two stages. First we determine the risk-return trade-off encountered when choosing between the risky and risk-free assets. Then we show how risk aversion determines the optimal mix of the two assets. This analysis leads us to examine so-called passive strategies, which call for allocation of the portfolio between a (risk-free) money market fund and an index fund of common stocks.

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