What portfolio allocation would you choose? Why? Explain your thinking carefully.

This is a very open-ended question. The asset allocation depends on the risk tolerance of the individual. However, most students will be young, so in this case, the portfolio allocation should be more heavily weighted toward stocks.

In any case, there should be little, if any, money allocated to the company stock. The principle of diversification indicates that an individual should hold a diversified portfolio. Investing heavily in company stock does not create a diversified portfolio. This is especially true since income comes from the company as well. If times get nasty for the company, employees face layoffs or reduced work hours. So, not only does the investment perform poorly, but income may be reduced as well. We only have to look at employees of Enron or WorldCom to see the potential for problems with investing in company stock. At most, 5 to 10 percent of the portfolio should be allocated to company stock.

Age is a determinant in the decision. Older individuals should be less heavily weighted toward stocks. A commonly used rule of thumb is that an individual should invest 100 minus their age in stores. Unfortunately, this rule of thumb tends to result in underinvestment in stocks.