INDUSTRIAL ENGINEERING APPLICATIONS IN FINANCIAL ASSET MANAGEMENT:TIME HORIZON

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TIME HORIZON

Beyond the taxation issue, a key component of MV problem specification is properly defining the horizon over which the optimization is applied. In particular, risk and correlation can differ signifi- cantly, depending on the time frame considered. For example, equities are much less risky over five- year horizons than over one year (Figure 8). This has led some analysts to argue for larger equity allocations for long-term investors because stock risk declines relative to bonds over lengthy horizons.

Industrial Engineering Applications in Financial Asset Management-0021

This issue is especially pertinent if illiquid assets such as private equity are to be included in the portfolio. Using annual volatility for private equity makes no sense—10-year risk must be considered.

In general, the longer the time horizon, the lower the risk for assets that appear to be risky when evaluated based on short-term data. As a consequence, long-horizon investors will allocate more to assets such as stocks and private equity. The reason for this is that annual risk is related to risk over other intervals by the identity ua = uTT1/2, where T is the periodicity of the data. Note that T = 4, 12, or 52 for quarterly, monthly, and weekly data and T = 1 / 2, 1 / 5, or 1 / 10 for 2-, 5-, and 10-year intervals. Thus, assets with high annual risk have exponentially declining risk over lengthy time intervals. This is why long-horizon portfolios often have relatively small allocations to fixed-income instruments and higher allocations to what are perceived as riskier assets (Figure 9). Some managers go as far as to suggest that a long-horizon investor hold 100% equities if they desire liquidity and the ability to exit portfolios at a time of their choosing.

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