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Portfolio Allocation Model

Portfolio Allocation Model. How to invest in different asset classes? Different people have different objectives/goals. Returns from investments are inherently random. How can we take this uncertainty into account and still make a reasonable decision?. Simple Spreadsheet Model.

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Portfolio Allocation Model

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  1. Portfolio Allocation Model • How to invest in different asset classes? • Different people have different objectives/goals. • Returns from investments are inherently random. How can we take this uncertainty into account and still make a reasonable decision?

  2. Simple Spreadsheet Model

  3. Asset Return Uncertainty (annualized) • Money Market • Uniform(minimum 2%, maximum 4%) • Income • Normal(mean 5%, stdev 5%) • Growth & Income • Normal(mean 7%, stdev 12%) • Aggressive Growth • Normal(mean 11%, stdev 18%)

  4. Crystal Ball • Define Assumption Cells for the annual returns • Define Forecast Cell • Set Simulation Settings (Number trials = 1000) • Run Simulation • View & Analyze Results • Run other two scenarios, complete summary table • Compare alternatives • (If no disk) Upload model to Blackboard Drop Box (toolsdigital drop box).

  5. Results • Summary Statistics • Mean, standard deviation, minimum, maximum, standard error • Frequency Distribution • Graphical, table of percentiles • Interactive use of frequency chart • What is the probability that the dollar return will be worse than $X? • What are the quartiles of the return distribution? What do they mean? • If I invest this way, at least how much should I be prepared to lose about 5% of the time?

  6. Goals/Objectives • Performance is a function of asset returns as well as asset allocation. • We cannot control returns, but we can control the allocation. • What is the “best” allocation? • Depends on the performance measure!

  7. Constrained Optimization • Objective (maximizing or minimizing) • Constraints • Decision Variables • Basic Question: What are the values of the decision variables which 1) satisfy the constraints, and 2) maximize or minimize the objective? • We will be using Solver soon in the course; however, Crystal Ball has a tool called OptQuest built in. • OptQuest is good for models which incorporate uncertainty, but is much slower than Solver for deterministic models.

  8. OptQuest • Build simulation model: define assumptions, forecast cells, and decision cells • CBTools…OptQuest • Wizard takes you through the process of specifying the optimization model. • Defining the objective: What is it you want to maximize or minimize?

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