3. Investing for the Long Run

Strategic Asset Allocation (SAA):

• Involves determining target allocations among asset classes and rebalancing periodically.
• Focused on long-term expectations rather than short-term financial crises.
• Influencing factors: return expectations, risk tolerance, time horizon, and investment objectives; these may change over time.
• Asset Classes:
• Traditional: money markets, bonds (incl. TIPS), equities.
• Alternative: real estate, hedge funds, private equity.
• New: commodities, art, energy, etc.

Capital Asset Pricing Model (CAPM):

• Formula: E(Ri) = Rf + βiM × (E(RM) - Rf)
• Key Components: Risk-free rate, stock market beta (β), and equity risk premium (E(RM) - Rf).

Historical Returns & Risk Premiums:

• Historical data indicates long-run equity returns are significantly higher than expected from risk-free rates.
• The equity premium puzzle discusses the disparity between expected equity premiums and actual returns against various risk factors.

Portfolio Rebalancing:

• A counter-cyclical strategy where we sell high-performing assets and buy underperforming ones to maintain target allocations.
• Long-term investors benefit from rebalancing, especially during market corrections.

Dynamic Portfolio Allocation:

• Investors should adapt portfolio weights over time based on market conditions and personal constraints.
• The essence is to approach investment as a dynamic process rather than a static one.

Liability Hedging:

• Investors with obligations (like pensions) should hold liability-hedging portfolios that correlate with their liabilities to ensure they can meet future financial commitments.

Investment Strategies & Performance:

• Dynamic allocation involves constant adjustments based on expected utility and changing market conditions, allowing for optimal long-term strategies.

Market Timing & Predictability:

• Returns can be predictable; thus, adaptive strategies can lead to better performance than stationary investments.