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Â So welcome to this lesson on strategic asset allocation.

Â And we're going to move from the modern portfolio theory concept

Â to how we implement this MPT optimization model in practice.

Â And in fact, I'm going to take you step by step.

Â We're going to make it very intuitively.

Â First of all, we're going to define what is a strategic asset allocation.

Â I'm going to give you two definitions, a practical one and an academic one.

Â Then we're going to talk about the key steps,

Â the six steps that can be identified in a SAA strategy,

Â which we will use now as the words strategic asset allocation is quite long.

Â And finally we're going to talk about the difficulties with estimating

Â the perimeters in the case of a strategic asset allocation process.

Â So SAA in fact has two definitions, one is a professional's one,

Â practitioner's one, and one which is the academic, and unfortunately they differ.

Â So let me start with how SAA is defined in practice.

Â It is a portfolio strategy which involves

Â finding the weights that you associate with each asset class.

Â The asset classes being stocks, bonds, convertible, cash, etc.

Â And then you rebalance the portfolio every time that you diverge from these

Â original weights, which are the target weights.

Â So let's see for instance, if the optimization tells you you have to invest

Â 40% in stocks, 60% in bonds, if after one year you depart from the 40 60,

Â you will rebalance the portfolio to get back to the 40 60 target allocation.

Â One issue which is very important is that the strategic asset allocation,

Â whether it's for practitioners or for academics, is over the long run and

Â over a long horizon, which I'm going to define within the next slide.

Â But the key assumption both for practitioners and for

Â academics is that over that long run horizon, the return parameters,

Â which means basically the mean returns of the asset classes, the variance covariance

Â matrix of these returns on the various asset classes, they do change over time.

Â So here comes the key difference between the practitioners' and

Â the academic view of strategic asset allocation.

Â What the academics will tell you is that when you set your target

Â portfolio weights and when you rebalance, you want to do that so

Â that you can hedge or protect yourself against changes in these parameters,

Â means, variances, covariances, over time.

Â Whereas the practitioners on Wall Street or

Â on Bahnhofstrasse don't tend to do that.

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Okay, so I tried to set six steps which

Â are crucial when you define a strategic sset allocation.

Â The first one is setting your investment horizon.

Â And if you look at different banks or

Â financial advisors, of course the lengths differ.

Â But let's say it's between three and ten year.

Â Of course a pension fund may want to set the target weights over a 20-year,

Â even a 30-year horizon.

Â But let's say three and ten are good ranges for this horizon.

Â Then you would define as a second step, the risk appetite of the investor.

Â How much is he willing to take risks on his portfolio?

Â Is he a risk lover, or is he very conservative in his strategy?

Â The third problem is some investors have constraints, so

Â you have to deal with those constraints.

Â They might be short selling constraints for

Â some institutions, there might be leverage constraints.

Â And the investor, for instance, may want to exclude some countries or

Â some industries, or overweight some industries because of his preferences.

Â And then we would use an optimization tool, and typically what most

Â professionals do, I found a quote which said that around 2010,

Â 7 trillion of assets managed by institutional investors would do

Â the optimization using the mark of its mean variance optimization to

Â the one that was explained to you by Professor Tony Berrada.

Â Of course, to do the optimization, you need to estimate the long

Â run return parameters, and that's going to be the tricky task.

Â And finally, to be close to the definition, each time that your weights

Â different from the target weights in each asset class, you will need to rebalance.

Â And typically, institutions give themself a one-year,

Â two-year horizon over which they keep the allocation and then rebalance.

Â Or they would rebalance after a major disruption like,

Â say, a market crash in a given country.

Â So let's look for instance at an example Charles Schwab,

Â which is used by most retail investors.

Â And if you go here from the right to the left,

Â you have on the right the conservative investor.

Â So this is Mr. Smith, who is very risk averse.

Â As you can see, he puts 20% of his money in cash and

Â all the rest within fixed income and cash instruments.

Â As you go to the moderately conservative investor,

Â he takes a little bit more risk and thus invests 40% in stocks.

Â And then when you come to a, let's say, more risk-loving appetite,

Â let's call him Mr. he would invest up to 60% of his investments in stocks,

Â whereas only 40% would be tilted between fixed income and cash.

Â Of course, there's no free lunch in an efficient market,

Â which means that the very conservative investor will have less risk but

Â also an average lower return performance.

Â And over the horizon 1970 to 2013,

Â he would have realized a little bit less than 8% per average per annum,

Â whereas the moderate investor who took more risk would

Â have realized almost 10% on average per year.

Â But remember he took more risk, so this is perfectly normal.

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Â