Heuristics, also known as rules of thumb, are simplistic and generic rules that investors use to satisfice. Satisficing, as covered in the behavioral economics section, reflects an attempt to reach a satisfactory economic decision at the expense of an optimal…

In rebalancing, securities within a portfolio are adjusted based on their relative weights. Disciplined rebalancing tends to reduce risk while incrementally adding to returns. Interpretations of this empirical finding include the following: Rebalancing earns a diversification return, in that rebalancing…

Risk budgeting is a means of making optimal use of risk to pursue return. A risk budget is optimal when the ratio of excess return to marginal contribution to total risk (MCTR) is the same for all assets in the…

An economic balance sheet differs from a traditional balance sheet as it includes tradable financial assets and non-tradable extended assets and liabilities. Extended assets often include the relatively large values of residential real estate and the present value of human…

Mean-variance optimization (“MVO”) forms the foundation for most modern asset allocation methods. MVO works by shifting the weights of asset classes within a portfolio until an optimal mix is found. An optimal mix is found when the portfolio has the…

Liability-relative approaches first view the cash flows of the sponsoring organization in question and then attempt to build a portfolio of securities that will satisfy these payments as they come due. This is in contrast to the popular asset-only approach…

Until this point in the curriculum, risk has been looked at through an asset class perspective, answering the question, ‘What risks are inherent in each asset class?’ Switching to a new paradigm, portfolios may be constructed when viewing risk not…

Client needs, and preferences would seem to be a qualitative factor. How, then, would an analyst include these factors into the quantitative models required to analyze a portfolio from the perspective of modern portfolio theory? The following three approaches are…

The problem of illiquid assets complicates traditional asset allocation. Some of the most prominent investments in this category include direct real estate, infrastructure, private equity, and hedge funds. Illiquidity and Lack of Investable Index Illiquid assets represent those for which…

 Shortcomings of Mean-Variance Optimization As discussed, mean-variance analysis can help investors and advisors begin to zero in on an asset allocation while considering asset correlations, total return, and total risk. Effectively use of MVO will result in a specific…