Client Needs and Preferences VS. Asset Allocation

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 common ways financial professionals attempt to tackle this issue:

Adding Additional Constraints

Adding additional constraints to the asset allocation is one way to control investor preferences. For example, a risk-averse investor could specify a limit to assets above a 20% standard deviation, follow Roy’s safety first criterion, or some other restriction. These restrictions help express mathematically what an investor may prefer or need.

Using a Risk Aversion Parameter

Risk aversion parameters, often shown as lambda \((\lambda)\), rank investors in terms of their attitudes towards risk. This variable is used for utility calculation. The higher the risk aversion parameter, the higher the penalty against incorporating riskier assets into the portfolio.

Going through Monte Carlo Simulations

An investor may not express a preference or need before the asset allocation process but may be allowed to peer into the future by seeing realistic and possible total wealth outcomes for a set of asset allocations. The investor and analyst can ‘try out’ various risk, correlation, and return values. If an investor prefers the newer outcomes, he can continue changing that variable in the same direction until a peak value or outcome is found.

Question

Which of the following is least likely a technique for expressing client desires and preferences in asset allocation?

1. Adding additional constraints.
2. Using Monte Carlo Simulation.
3. Using a return-aversion parameter.

Solution

The correct answer is C:

The option choice should read ‘risk-aversion parameter,’ as used in the utility calculation.

A and B are incorrect. The other two choices are standard techniques.

Asset Allocation: Learning Module 4: Principles of Asset Allocation; Los 4(h) Describe how client needs, and preferences regarding investment risks can be incorporated into asset allocation