Asset Allocation & Risk Management Flashcards

What is the main objective of asset allocation?

Answer: Balance risk and return

The main objective of asset allocation is to balance risk and return within an investment portfolio. By strategically distributing investments across various asset classes, asset allocation aims to achieve the highest possible return for a given level of risk, or conversely, the lowest possible risk for a desired level of return. It's about optimizing the risk-reward tradeoff to align with an investor's specific goals and risk tolerance.

Which factor is most critical in determining an investor’s asset allocation?

Answer: Risk tolerance

An investor's risk tolerance is the most critical factor in determining their asset allocation because it dictates how much investment volatility they are willing and able to endure. A higher risk tolerance typically allows for a greater allocation to growth-oriented assets like stocks, while a lower risk tolerance necessitates a more conservative allocation to assets like bonds. This ensures the portfolio aligns with the investor's comfort level and ability to withstand market fluctuations.

What is systematic risk?

Answer: Risk affecting the whole market

Systematic risk, also known as market risk or non-diversifiable risk, refers to the inherent uncertainty that affects the entire market or a large segment of it. This type of risk cannot be eliminated through diversification because it stems from macroeconomic factors such as interest rate changes, inflation, recessions, or political events. Investors are compensated for bearing systematic risk through higher expected returns.

Which of the following is a passive asset allocation strategy?

Answer: Strategic asset allocation

Strategic asset allocation is a passive investment strategy that involves setting target allocations for various asset classes and periodically rebalancing the portfolio to maintain those targets. This approach is long-term oriented, based on the investor's risk tolerance and financial goals, and assumes that market timing is difficult. It contrasts with active strategies that attempt to outperform the market through frequent adjustments.

Which investment approach focuses on adjusting the portfolio based on short-term market predictions?

Answer: Tactical asset allocation

Tactical asset allocation is an investment approach that focuses on actively adjusting the portfolio's asset class weights based on short-term market predictions and economic forecasts. Unlike strategic allocation, which maintains fixed targets, tactical allocation attempts to capitalize on perceived market inefficiencies or short-term trends. This approach aims to enhance returns or reduce risk over shorter periods by overweighting favored asset classes and underweighting others.

What role does diversification play in risk management?

Answer: Reduces asset-specific risk

Diversification is a risk management strategy that involves investing in a variety of assets to minimize the impact of any single investment's poor performance on the overall portfolio. By spreading investments across different asset classes, industries, and geographies, diversification effectively reduces idiosyncratic or asset-specific risk. While it does not eliminate systematic market risk, it helps smooth out portfolio returns by ensuring that not all investments move in the same direction at the same time.