CM F89 - Asset Allocation* *CLOSED FOR FURTHER ENROLMENT*

Faculty
Marcel Marekwica

Course Coordinator
Marcel Marekwica

The course Asset Allocation builds on introductory finance courses like “Financial Markets and Instruments” for instance. A good working knowledge in linear algebra as well as calculus, optimization and basic concepts of probability theory are very helpful to follow the course.

The objective of the course ''Asset Allocation'' is to enable you to make ''clever'' portfolio choice decisions based on more advanced portfolio choice models than Markowitz -- irrespective of whether you want to use these skills in your profession or just want to manage your own private portfolio an intelligent way. In order to do so, it is both the objective of the course to give you an overview of portfolio choice models and their limits as well as to provide you with the necessary mathematical tools that are required to compute these portfolios.

After a brief introduction into the concepts of preferences and utility that are required for understanding what properties optimal portfolio should have, we turn to different risk measures. We will argue that standard deviation (as used in the Markowitz model) only covers some part of the risk investors are facing in the market.

Having discussed these concepts, we are able to turn to the core part of the course, namely portfolio choice models. We first turn to one-period models where (as e.g. in the Markowitz model) it is assumed that the investor’s investment horizon is one period. In particular, the investor once chooses his portfolio and then holds it until the end of his investment horizon. After a brief recap of the famous Markowitz model and discussing its limitations, we will turn to several extensions of this approach that try to overcome some of these limitations. In addition, we will cover portfolio choice models that have been quite successful from an empirical point of view. In particular, we will discuss so-called Fama/French portfolios as well as parametric portfolios.

In the presence of market frictions, we will argue that one-period models may not be sufficient to cover the dynamics of varying investment opportunity sets. Such variations in the investment opportunity set might e.g. be caused by time-varying labor income, wash sale constraints, transaction costs, and the illiquidity of housing wealth or tax-effects for instance. Introducing these factors into portfolio choice models complicates finding optimal portfolios by an order of magnitude. However, choosing a portfolio based on a model that does not take these frictions into account can result in suboptimal portfolis. One of the most important market frictions private investors are dealing with are taxes. We will see that tax-effects can significantly alter portfolio choice. Tax-effects we will consider include tax-timing options (capital gains are not taxed when they occur, but when they are realized), the different taxable treatment of capital gains and losses (when you realize capital gains you are subject to taxation, when you realize losses you are only endowed with a tax loss carry-forward you can offset in forthcoming periods) and the different taxable treatment of profits in retirement and conventional savings accounts. In particular, making “clever” portfolio choice decisions for retirement is an issue that is of significant importance to private investors. Especially due to the length of the investment horizon the impact of portfolio choice on the distribution of wealth private investors are endowed with when retiring is substantial.

The focus of the course Asset Allocation will be on factors driving optimal portfolio choice and discussing methods how optimal portfolios can be determined. Even though the course can be followed without attending other elective courses, actively participating in “Financial Models in Excel” where some of the portfolio choice models discussed in class are implemented, might be a clever combination of courses and should help deepening the understanding of those models.

To attain the top grade, students are required to have a deep understanding of the field of asset allocation and the various factors affecting optimal portfolio choice. This – among others – includes

4 hour written final exam without aids. Besides pens students are only allowed to bring a non-programmable calculator without graphical display.

Given that teaching some of the most recent innovations in portfolio choice is a key objective of the course, there is no text book available covering all the portfolio choice models that will be dealt with throughout the course. The lecturer will provide students with a set of detailed lecture notes of around 100 pages covering all topics of the course. In order to deepen the contents of the course, it is recommended to read the articles below, the lecture notes are based on: