Asset allocation decision that are based on a mean-variance framework requires t
ID: 2616943 • Letter: A
Question
Asset allocation decision that are based on a mean-variance framework requires the assumption that returns from these assets are normally distributed. However, traditional asset classes and alternative investments (such as Hedge Funds, Private Equities, and Venture Capital funds) are shown to have non-normal return distribution. How should an investor decide the level of alternative investment in their portfolios? 1. Explain what is the mean variance framework? 2. Explain what is meant by normal and non-normal distribution? 3. Explain the impact of using non-normally distributed assets in the MV framework? 4. Give two suggestions to overcome this issue.Explanation / Answer
1) Mean Variance framework is a mathematical framwork that includes two parameters mean return and variance. This framework is used by investor in chosing among various alternatives available for investment. The investor tries to acheives the maximum return possible at a given level of risk or at the lowest level of risk. Thus, this framework makes investor to behave rationally and chose investment that generates higher return for a given level of risk.
2) A normal distribution is a distribution in which mean is equal to mode is equal to median. In such distribution, the curve is bell shaped and symmetrical. A non normal distribution is a distribution in which the central tendencies to measure are different and the graph is either positively or negatively skewed.
3) Usage of non normal data in MV framework may not give a true and comprehensive picture of analysis. A non normal distribution is skewed which makes the analysis biased and hence the analysis will be skewed in either positive and negative direction. Hence it is very important to make the distribution normal by applying some econometrics test before applying MV framework.
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