Which of the following portfolios best represents a suitable asset allocation for a risk-averse investor?
I. Cash/money market fund: 20%; government bonds: 10%; investment-grade bonds: 15%; foreign stocks: 10%; blue-chip stocks: 25%; high-yield bonds: 10%; small cap stocks: 10%
II. Cash/money market fund: 30%; government bonds: 20%; investment-grade bonds: 15%; foreign stocks: 3%; blue-chip stocks: 25%; high-yield bonds: 0%; small cap stocks: 7%
III. Cash/money market fund: 10%; government bonds: 5%; investment- grade bonds: 10%; foreign stocks: 15%; blue-chip stocks: 25%; high-yield bonds: 10%; small cap stocks: 25%
Explanation
Answer: B - The asset allocation described in Selection II best represents a suitable asset allocation for a risk-averse investor. A risk-averse investor will have the greatest percentage of his funds invested in cash/money market fund. The bulk of his remaining funds will be invested in high-quality bonds, e.g., U.S. government bonds and investment-grade corporate bonds, and blue-chip stocks. He may choose to invest a little in foreign stocks and in small caps for additional diversification and a bit more growth potential. The portfolio presented in Selection II has 30% invested in the money market fund, 35% in high-quality bonds, 25% in blue-chip stocks and only 3% in foreign stocks and 7% in small caps. In contrast, Selection I has a riskier allocation with 20% invested in the money market fund and only 50% invested in high-quality bonds and blue chip stocks; the remaining 30% is invested in riskier assets-high-yield (junk) bonds, foreign stocks, and small cap stocks. Selection III is riskier still with only 10% in a money market fund, 40% in high-quality bonds and blue-chips, and 50% in the riskier three asset categories. Even a risk-averse investor should not be entirely invested in government securities and/or money-market funds; his purchasing power risk would be extremely high, and he would have no opportunity for capital appreciation.
