The Asset Allocation

Decision
1. Individual Investor Life Cycle
2. The Portfolio Management Process
3. The Need for a Policy Statement
4. Input to the Policy Statement
5. The Importance of Asset Allocation
6. Asset Allocation and Cultural Differences
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 1. Individual Investor life Cycle
 Investment needs change over a person’s life
cycle.
 How individuals structure their financial plans
should be related to their age, financial status,
future plans, and needs.
– The preliminaries
– Life cycle investment strategies
– Life cycle investment goals

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 The Preliminaries
• Insurance • Cash reserve
Insurance
 Life insurance
– Protects loved ones against financial hardship
should death occur before financial goals are
meet
– Term life insurance - Provides death benefit
only. Premium could change every renewal
period
• Health insurance • Automobile insurance
• Disability insurance • Home/rental insurance
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 Cash Reserve
 To meet emergency needs
 Includes cash equivalents (liquid investments)
 Equal to six months living expenses
recommended by experts

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Life cycle investment strategies(1)
 Accumulation phase
– In early-to-middle years of their working careers
– Their net worth is small
– Making fairly high-risk and long-term investments
 Consolidation phase
– Past the midpoint of their careers
– Earnings exceed expenses
– Making moderate-risk and long-term investments

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Life cycle investment strategies(2)
 Spending phase/Gifting phase
– Begins after retirement (Individual retire)
– Living expenses are covered by Social Security
income and income from prior investments,
including employer pension plans
– Making less-risk investments
– Have sufficient income to cover their expenses
– Provide assistance to relatives and friend, etc.

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 Individual Investor Life Cycle
Net Worth Exhibit 2.1

Accumulation Phase Consolidation Phase Spending Phase

Gifting Phase
Long-term: Long-term:
Retirement Retirement Long-term:
Children’s college Estate Planning
Short-term:
Short-term: Vacations Short-term:
House Car Children’s College Lifestyle
Needs Gifts

Age
25 35 45 55
Chapter 2 The Asset Allocation Decision
65 7
75
 Life cycle investment goals
 Near-term, High-priority goals
– Shorter-term financial objectives, such as a house
down payment
 Long-term, High-priority goals
– Typically include the ability to retire at a certain
age
 Lower-priority goals
– Not critical, e.g., buying a new car

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 2. The Portfolio Management
Process
 Four steps of the portfolio management process
– (1) Policy statement
– (2) Examine current financial, economic,
political,and social conditions
– (3) Implement the plan by constructing the
portfolio
– (4) Feedback loop
– As seen Exhibit 2.2 on next slide

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 Exhibit 2.2

The Portfolio Management Process

(1) Policy statement - Focus: Investor’s short-term and long-
term needs, familiarity with capital market history, and
expectations
(2) Examine current and project financial, economic,
political, and social conditions - Focus: Short-term and
intermediate-term expected conditions to use in
constructing a specific portfolio
(3) Implement the plan by constructing the portfolio - Focus:
Meet the investor’s needs at the minimum risk levels

(4) Feedback loop: Monitor and update investor needs,

environmental conditions, portfolio performance

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The Portfolio Management Process
 (1) Policy statement
– Specifies investment goals, constraints and risk
preferences
– Should be reviewed periodically
– Guides all investment decisions
 (2) Investment Strategy
– Study current financial and economic conditions and
forecast future trends
– Determine strategies to meet goals
– Requires monitoring and updating

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The Portfolio Management Process
 (3) Construct the portfolio
– Allocate available funds to minimize investor’s
risks and meet investment goals
 (4) Monitor and update
– Evaluate portfolio performance
– Monitor investor’s needs and market conditions
– Revise policy statement as needed
– Modify investment strategy accordingly

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3. The need for a policy statement

 Understand and Articulate Investor Goals

 Standards for Evaluating Portfolio
Performance
 Other Benefits

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 Understand and Articulate
Investor Goals
– An important purpose of writing a policy
statement is to help investors understand their
needs, objectives, and investment constraints
– To be familiar with financial markets
– The policy statement helps the investor to
specify realistic goals and become better
informed about the risks and costs of investing

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 Standards for Evaluating
Portfolio Performance
 Setsstandards for evaluating portfolio
performance
– The policy statement is also the basis for judging
the performance of the portfolio manager
– Benchmark portfolio or Comparison standard: A
comparison standard of risk and assets included in
the policy statement

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 Other Benefits

 Reduces the possibility of inappropriate

behavior on the part of the portfolio
manager
– A sound policy statement helps to protect the client
against a portfolio manager’s inappropriate
investments or unethical behavior

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4. Input to the Policy Statement

 Investment Objectives
 Investment Constraints

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 Investment Objectives
 The investor’s objectives are his or her
investment goals expressed in terms of both
risk and returns.
 Risk Tolerance – affected by individual’s
psychological makeup, current insurance
coverage, cash reserve and family situation.
 Return objective may be stated in terms of an
Absolute or relative percentage return.

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 General goals
 Capital preservation- Minimize risk of real loss. The
return needs to no less than the rate of inflation.
 Capital appreciation- Growth of the portfolio in real
terms to meet future need. Growth mainly occurs through
capital gains.
 Current income- Focus is in generating income rather than
capital gains. Help to generate spendable funds.
 Total return- Increase portfolio value by capital gains and
by reinvesting current income.
– Has both income and capital gain components
– Maintain moderate risk exposure

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 Investment Constraints
 Liquidity needs- An asset is liquid if it can be quickly
converted to cash at the price close to fair market value. Vary
between investors depending upon age, employment, tax status.
 Time horizon- Long term & short term. A close relationship
exist between an investor’s time horizon, liquidity needs and
ability to handle risk.
 Tax concerns- Investment planning is complicated by the
tax code. Taxes complicated the situation even more if
international investments are part of the portfolio.
 Legal and regulatory factors- Investment process and financial
markets are highly regulated and subject to numerous laws.
 Unique needs and preferences- Say no to the firms that
manufacture or sell tobacco, alcohol and environmentally
harmful products.
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Unique Needs and Preferences
 Personal preferences such as socially conscious
investments could influence investment choice
 Time constraints or lack of expertise for managing
the portfolio may require professional management
 Large investment in employer’s stock may require
consideration of diversification needs
 Institutional investors needs

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Constructing the Policy Statement
 Objectives - risk and return
 Constraints - liquidity, time horizon, tax
factors, legal and regulatory constraints, and
unique needs and preferences
 Developing a plan depends on
understanding the relationship between risk
and return and the the importance of
diversification

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 Constructing A Policy Statement
Questions to be answered:
– What are the real risks of an adverse financial outcome, especially
in the short run?
– What probable emotional reactions will I have to an adverse
financial outcome?
– How knowledgeable am I about investments and the financial
markets?
– What other capital or income sources do I have? How important is
this particular portfolio to my overall financial position?
– What, if any, legal restrictions may affect my investment needs?
– What, if any, unanticipated consequences of interim fluctuations in
portfolio value might affect my investment policy?

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 5. The Importance of Asset
Allocation

 Real Investment Returns after Taxes and Costs

 Returns and Risks of Different Asset Classes

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 Real Returns and Investment
Strategies
 An investment strategy is based on four decisions
– What asset classes to consider for investment
– What normal or policy weights to assign to each eligible class
– Determining the allowable allocation ranges based on policy
weights
– What specific securities to purchase for the portfolio
 According to research studies, most (85% to 95%) of the
overall investment return is due to the first two
decisions, not the selection of individual investments
– See Exhibit 2.5 on page 35

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 Real Investment Returns after
Taxes and Costs
 For taxable investments, the only way to
maintain purchasing power over time when
investing in financial assets is to invest in
common stock.
Compound Annual Before taxes After taxes
After taxes
Returns: 1926-2001 and inflation and inflation
Common Stocks 10.7% 7.9% 4.7%
Long-Term Govt. Bonds 5.3% 3.7% 0.6%
Treasury Bills 3.8% 2.7% -0.4%
Municipal Bond (est.) 6.0% 6.0% 2.9%

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 Returns and Risk of Different
Asset Classes
 The higher returns available from equities also include higher
risk.
 Historically, small company stocks have generated the highest
returns. But the volatility of returns have been the highest too.
 The asset allocation decision determines to a great extent both
the returns and volatility of the portfolio.
 Inflation and taxes have a major impact on returns
 Returns on Treasury Bills have barely kept pace with inflation.
 Measuring risk by probability of not meeting your investment
return objective indicates risk of equities is small and that of T-
bills is large because of their differences in expected returns

Chapter 2 The Asset Allocation Decision 27

Thank You

Chapter 2 The Asset Allocation Decision 28