Portfolio Management

CHAPTER 3Asset Allocation: The Mean - Variance Framework

Chapter Outline

1. 3.1 Introduction: Motivation of the Mean–Variance Approach to Asset Allocation
2. 3.2 Theory: Outline of the Mean–Variance Framework
3. 3.3 Practice: Solution of Stylized Problems Using the Mean–Variance Framework
   1. Summary
   2. Problems
   3. Appendix 1: Returns, Compounding, and Sample Statistics
   4. Appendix 2: Optimization
   5. Appendix 3: Notation
   6. Endnotes

3.1 INTRODUCTION: MOTIVATION OF THE MEAN–VARIANCE APPROACH TO ASSET ALLOCATION

Asset allocation is the term used to describe the set of weights of broad classes of investments within a portfolio. Once an investor's goals and objectives have been defined, setting the asset allocation target is the first step in developing an investment program. These weights will define the overall behavior of the portfolio and should be set to match the risk and return targets for the investor. For example, an investor concerned about total return risk would tend to have a higher weight in money market funds than would a more risk-tolerant investor. Asset allocation techniques represent tools that help professionals set optimal mixes. Different techniques may be used for short-term and long-term investment horizons, but they all have the same goal of setting proportional investments.

Asset allocation tools can help solve many investment problems, including those faced by individual investors, defined benefit pension (DB) plans, defined contribution (401(k)) plans, endowments, and foundations. ...