The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

ESTABLISHING AN INVESTMENT POLICY

Establishing an investment policy starts with the asset allocation decision. That is, a decision must be made as to how the funds to be invested should be distributed among the major classes of assets.

Asset Classes

Throughout this book, we refer to certain categories of investment products as an “asset class.” In the next chapter, we take a closer look at what is meant by an asset class. From the perspective of a U.S. investor, the convention is to refer to the following as traditional asset classes: U.S. common stocks, non-U.S. (or foreign) common stocks, U.S. bonds, non-U.S. (or foreign) bonds, cash equivalents, and real estate. Common stock and bonds are further divided into different asset classes. Cash equivalents are defined as short-term debt obligations that have little price volatility. In addition to the traditional asset classes, there are asset classes commonly referred to as alternative assets or alternative investments. Two of the more popular ones are hedge funds and private equity. In the next chapter, we review three popular alternative assets.

Constraints

There are some institutional investors that make the asset allocation decision based purely on their understanding of the risk-return characteristics of the various asset classes and expected returns. The asset allocation will take into consideration any investment constraints or restrictions. Asset allocation models are commercially available for assisting those individuals ...