[MUSIC] So welcome to this lesson on strategic asset allocation. And we're going to move from the modern portfolio theory concept to how we implement this MPT optimization model in practice. And in fact, I'm going to take you step by step. We're going to make it very intuitively. First of all, we're going to define what is a strategic asset allocation. I'm going to give you two definitions, a practical one and an academic one. Then we're going to talk about the key steps, the six steps that can be identified in a SAA strategy, which we will use now as the words strategic asset allocation is quite long. And finally we're going to talk about the difficulties with estimating the perimeters in the case of a strategic asset allocation process. So SAA in fact has two definitions, one is a professional's one, practitioner's one, and one which is the academic, and unfortunately they differ. So let me start with how SAA is defined in practice. It is a portfolio strategy which involves finding the weights that you associate with each asset class. The asset classes being stocks, bonds, convertible, cash, etc. And then you rebalance the portfolio every time that you diverge from these original weights, which are the target weights. So let's see for instance, if the optimization tells you you have to invest 40% in stocks, 60% in bonds, if after one year you depart from the 40 60, you will rebalance the portfolio to get back to the 40 60 target allocation. One issue which is very important is that the strategic asset allocation, whether it's for practitioners or for academics, is over the long run and over a long horizon, which I'm going to define within the next slide. But the key assumption both for practitioners and for academics is that over that long run horizon, the return parameters, which means basically the mean returns of the asset classes, the variance covariance matrix of these returns on the various asset classes, they do change over time. So here comes the key difference between the practitioners' and the academic view of strategic asset allocation. What the academics will tell you is that when you set your target portfolio weights and when you rebalance, you want to do that so that you can hedge or protect yourself against changes in these parameters, means, variances, covariances, over time. Whereas the practitioners on Wall Street or on Bahnhofstrasse don't tend to do that. Okay, so I tried to set six steps which are crucial when you define a strategic sset allocation. The first one is setting your investment horizon. And if you look at different banks or financial advisors, of course the lengths differ. But let's say it's between three and ten year. Of course a pension fund may want to set the target weights over a 20-year, even a 30-year horizon. But let's say three and ten are good ranges for this horizon. Then you would define as a second step, the risk appetite of the investor. How much is he willing to take risks on his portfolio? Is he a risk lover, or is he very conservative in his strategy? The third problem is some investors have constraints, so you have to deal with those constraints. They might be short selling constraints for some institutions, there might be leverage constraints. And the investor, for instance, may want to exclude some countries or some industries, or overweight some industries because of his preferences. And then we would use an optimization tool, and typically what most professionals do, I found a quote which said that around 2010, 7 trillion of assets managed by institutional investors would do the optimization using the mark of its mean variance optimization to the one that was explained to you by Professor Tony Berrada. Of course, to do the optimization, you need to estimate the long run return parameters, and that's going to be the tricky task. And finally, to be close to the definition, each time that your weights different from the target weights in each asset class, you will need to rebalance. And typically, institutions give themself a one-year, two-year horizon over which they keep the allocation and then rebalance. Or they would rebalance after a major disruption like, say, a market crash in a given country. So let's look for instance at an example Charles Schwab, which is used by most retail investors. And if you go here from the right to the left, you have on the right the conservative investor. So this is Mr. Smith, who is very risk averse. As you can see, he puts 20% of his money in cash and all the rest within fixed income and cash instruments. As you go to the moderately conservative investor, he takes a little bit more risk and thus invests 40% in stocks. And then when you come to a, let's say, more risk-loving appetite, let's call him Mr. he would invest up to 60% of his investments in stocks, whereas only 40% would be tilted between fixed income and cash. Of course, there's no free lunch in an efficient market, which means that the very conservative investor will have less risk but also an average lower return performance. And over the horizon 1970 to 2013, he would have realized a little bit less than 8% per average per annum, whereas the moderate investor who took more risk would have realized almost 10% on average per year. But remember he took more risk, so this is perfectly normal. [MUSIC]