- 120% - 100% - 80% - g 60% - 1 40% - = 20% - 0% -20% - -40% - -60% - United States ■ 1980-1990 □ 1991-2001 FIGURE 9.2 Optimal Portfolio Weights Japan BENEFITS OF AH EQUILIBRIUM APPROACH_________________ An equilibrium approach gives investors three specific advantages over standard approaches to strategic asset allocation. First, it provides a more theoretically correct neutral point. Second, an equilibrium approach relies on more easily observable and estimable information. Finally, an equilibrium approach enables investors to more easily identify and understand the key trade-offs. As discussed in previous chapters, the predictions of asset-pricing theory are quite clear: When capital markets are in equilibrium, investors should hold a portion of their wealth in the market portfolio. The remaining portion of an investor's wealth should be held in either cash or debt. Investors would hold cash if they were not willing to tolerate portfolio risk at the level of the market portfolio. They would issue debt (i.e., become levered) if they were willing to take more risk than the market portfolio. These predictions are independent of the investor's geographic region or industry type. Thus, the market portfolio provides a meaningful starting point for portfolio analysis: Differences between investor types (geographic region or clientele type) can be understood in terms of deviations from the market portfolio. Applying an equilibrium approach in practice is relatively straightforward. As a first step, investors must identify a suitable market portfolio. That is, investors must determine the market value of all assets, and perhaps express these values as percentages of the total value of all assets. As discussed in Chapter 8, for most publicly traded securities markets this step is relatively straightforward. Most of the world's publicly traded equity markets are valued daily. Similarly, daily valuations are available on most government bond markets. For other asset classes, valuations are likely to occur less frequently. That caveat notwithstanding, it is feasible for investors to get assessments of the value of the market portfolio on a regular basis. A second ingredient that is necessary for investors to apply an equilibrium approach is some notion of the risk characteristics of each of the asset classes. Volatility and correlation of asset returns are important because investors must judge whether they would like their portfolios to have more or less risk than the market