Many asset allocation models base their frameworks on various economic, statistical and financial fundamentals, such as the Modern Portfolio Theory (MPT), which deals with market prices and their influences and is the basis on which more models were founded. Statistical models, such as covariance and correlation of returns, are designed to measure the relationship between different assets' returns. These asset allocation models and their counterparts have a purpose to help investors make decisions in financial planning. They can also be used to fit any risk tolerance level, investment horizon and investment goal.
Certain experts will classify the asset allocation models according to their main function. For example, MPT and the Efficient Market Theory address how information influences market prices. Models such as standard deviation of distribution, mean of distribution, normal probability distribution, variance and semi-variance of distribution and Z-score deal with the returns of assets and how they are scattered around their averages.
The R Squared coefficient of determination, covariance of returns and correlation of returns evaluate different assets and how their returns relate to each other. With a purpose of taming risk while enhancing returns, an investor might use one or a combination of the following: efficient frontier, Sharpe ratio, Sortino ratio, Treynor ratio and mean-variance optimization. Alpha and beta, Capital Asset Pricing Model (CAPM), Capital Market Line and Security Market Line are tools to quantify the return that an investor expects to receive for taking on a certain amount of risk.
The CAPM, for instance, measures risk and return in a portfolio. Using this model, an investor can employ what is known as the beta coefficient to calculate the volatility of a stock or bond in relation to the wider market. He or she can also use the alpha coefficient to measure the performance of an individual stock or bond and the profits that this security is able to produce regardless of what the broader market is doing.
Whether a particular individual's investment strategy is for growth, the many asset allocation models available can possibly help him or her measure and control risk and seek to maximize returns. The same is true for the conservative investor who has a fixed-income investment goal. The moderate investor might benefit from the models by finding the right balance for his or her needs. These models' main function is to help an investor measure risk and reward, and to minimize the former without compromising the latter, by finding the ideal asset mix for his or her objectives.
Asset allocation models can help investors make fruitful decisions, but one needs to realize that there is no model that can make accurate calculations. This is because that are many outside factors and unexpected variables that can cause these models to break down. Thus, investors are usually counseled to try to understand the shortcomings of these asset allocation models so they won't blindly rely on their computations.
