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Asset Allocation & Portfolio Construction: A Practical Case
September, 2016
[To Be Added]



Whether for the sake of trying to make a fortune or for the sake of knowledge, both practitioners
and academicians have had interests in studying the behavior of financial time series data since the
existence of financial markets. Not only their motives were different, but also their practices. On one
hand, financial practitioners believed that financial time series can be forecasted. Driven by their
financial motives, they were set to exploit profit opportunities by forecasting and predicting the
behavior of financial time series in capital markets. Academicians, on the other hand, were occupied
with answering the question of whether or not it is possible to forecast financial time series. Despite
their different motives, they both enhanced our understanding of the price formation process in
financial markets.
Academicians contributed equilibrium models that aim to describe the process of price formation
in the financial market. Over time, two schools of thoughts were established. Proponents of the
first school of thought believed that resources are efficiently allocated among participants in capital
markets. In an efficient setup, capital markets provide accurate signals for firms and investors that
enable them to make efficient investment decisions. In other words, the proponents of this school
of though entertained the Efficient Markets Hypothesis (EMH), which posits that, at any point
in time, security prices fully reflect all available information in the market. Empirical evidence,
however, shows otherwise. The EMH does not hold all the time. Recent evidence from behavioral
finance and neurosciences shows that investors (especially retail traders) exhibit irrational behavior,
which can explain this violation of the EMH. This led to the formation of the second school of
thought,-the behavioral finance school.
Practitioners are not interested in developing models of price formation; rather they are interested in developing techniques to analyze and predict the price movements. Same as academicians,
practitioners are also divided into two schools of thought: the fundamental analysis school and the
technical analysis school. Although both schools of thought share the same objective, which is to
give advise on what and when to buy and sell assets for the sake of making profit, they differ in
their ways of analysis. The proponents of the fundamental analysis believe that any asset has a
foundation value or intrinsic value. Due to market conditions, the actual price of the asset fluctuates continuously around this intrinsic value; it could fall below or rise above this value. This
fluctuation implies that the actual market price of the asset will eventually reach its intrinsic value