Chapter 2 - The Asset Allocation Decision

Saif [email protected]@yahoo.com+923216633271

Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Sixth Editionby

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Chapter 2

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SAIF ULLAH, [email protected], +923216633271

Chapter 2The Asset Allocation Decision

Questions to be answered:• What is asset allocation?• What are the four steps in the portfolio

management process?• What is the role of asset allocation in

investment planning?• Why is a policy statement important to the

planning process?


Chapter 2The Asset Allocation Decision

• What objectives and constraints should be detailed in a policy statement?

• How and why do investment goals change over a person’s lifetime and circumstances?

• Why do asset allocation strategies differ across national boundaries?


Individual InvestorFinancial Plan PreliminariesInsurance

– Life insurance



– Life insurance• Term life insurance - death benefit

only, increasing premium at renewal

• Cash value life insurance - death benefit plus savings plan



– Health insurance - medial bills



– Disability insurance - income



– Property insurance - your home or automobile



– Liability insurance - damage to others or their property


Individual InvestorFinancial Plan PreliminariesCash reserve


Individual InvestorFinancial Plan PreliminariesCash reserve

– To meet emergency needs• Six-month living expense reserve

– Liquid investments• Easily converted to cash without loss

of value


Individual InvestorLife Cycle

• Accumulation phase

• Consolidation phase

• Spending phase

• Gifting phase


Individual Investor Life Cycle

25 35 45 55 65 75

Net Worth

Age

Accumulation Phase

Long-term: Retirement Children’s college

Short-term: House Car

Consolidation Phase

Long-term: Retirement

Short-term:

Vacations

Children’s College

Spending Phase Gifting Phase

Long-term: Estate Planning

Short-term: Lifestyle Needs Gifts

Figure 2.1


Life Cycle Investment Goals

• Near-term, high-priority goals

• Long-term, high-priority goals

• Lower-priority goals


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

Figure 2.2



1. Policy statement– specifies investment goals and

acceptable risk levels

– should be reviewed periodically

– guides all investment decisions



2. Study current financial and economic conditions and forecast future trends– determine strategies to meet goals

– requires monitoring and updates



3. Construct the portfolio– allocate available funds to meet

goals and minimize investor’s risks



4. Monitor and update– revise policy statement as needed

– modify investment strategy accordingly

– evaluate portfolio performance


The Need For A Policy Statement

• Understand and articulate realistic investor goals

– needs, objectives, and constraints

– financial markets and risks of investing


Constructing A Policy Statement

• 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 markets?


Constructing A Policy Statement

• 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?


Standards For Evaluating Portfolio Performance

• Benchmark portfolio– risk and return

• Matches risk preferences and investment needs– analysis of risk tolerance

– return objective goals


Realistic Investor Goals• Capital preservation

– minimize risk of real loss– strongly risk-averse or funds needed soon

• Capital appreciation– capital gains to provide real growth over time for

future need– aggressive strategy with accepted risk

• Current income– generate spendable funds


Realistic Investor Goals

• Total return– capital gains and income reinvestment– moderate risk exposure


Investment Constraints

• Liquidity needs– near-term goals

• Time horizon– longer time horizon favors risk acceptability– short time horizon favors less risky investments

because losses are harder to overcome in a short time frame



• Tax concerns– interest and dividends taxed at investor’s

marginal tax rate– capital gains may be unrealized– basis and gain or loss realized– revisions to capital gains tax rates– tradeoff with diversification needs for

employer’s stock holdings



• Tax concerns (continued)

– interest on municipal bonds exempt from federal income tax and from state of issue

– interest on federal securities exempt from state income tax

– contributions to an IRA may qualify as deductible from taxable income

– tax deferral considerations - compounding


Equivalent Taxable Yield

RateTax Marginal1

Yield MunicipalETY


Effect of Tax Deferral on Investor Wealth over Time

0 10 20 30 years

8% TaxDeferred

5.76%After TaxReturn

$1,000

Investment Value

Time

$10,063

$5,365

Figure 2.5


Methods of Tax Deferral

• Regular IRA - tax deductible– withdrawals taxable

• Roth IRA - not tax deductible– tax-free withdrawals possible

• Cash value life insurance

• Annuities

• Employer’s 401(k) and 403(b) plans


Legal and Regulatory Factors

• Limitations or penalties on withdrawals

• Fiduciary responsibilities - “prudent man” rule

• Investment laws prohibit insider trading


Unique Needs and Preferences• Personal preferences - socially conscious

investments• Time constraints or expertise for managing the

portfolio may require professional management• Large investment in employer may require

consideration of diversification needs and realistic liquidity

• Institutional investors needs


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 importance of diversification


The Importance of Asset Allocation

• 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– The allowable allocation ranges based on policy

weights– What specific securities to purchase for the

portfolio


The Importance of Asset Allocation

• Most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments


The Effect of Taxes and Inflation on Investment Returns, 1926 - 1998

-2

0

2

4

6

8

10

12Common Stocks

Long-TermGovernmentBondsTreasury Bills

Municipal Bonds

After Taxes and

Inflation

After Taxes

Before Taxes

Figure 2.6


Returns and Risk of Different Asset Classes

• Higher returns compensate for risk

• Policy statements must provide risk guidelines

• Measuring risk by standard deviation of returns over time indicates stocks are more risky than T-bills


Returns and Risk of Different Asset Classes

• Measuring risk by probability of not meeting your investment return objective indicates risk of equities is small and risk of T-bills is large because of different expected returns

• Focusing only on return variability ignores reinvestment risk

• Changes in returns from year to year


Asset Allocation Summary

• Policy statement determines types of assets to include in portfolio

• Asset allocation determines portfolio return more than stock selection

• Over long time periods sizable allocation to equity will improve results

• Risk of a strategy depends on the investor’s goals and time horizon


Asset Allocation and Cultural Differences

• Social, political, and tax environments

• U.S. institutional investors average 45% allocation in equities

• In the United Kingdom, equities make up 72% of assets

• In Germany, equities are 11%

• In Japan, equities are 24% of assets


Summary

• Develop an investment policy statement– Identify investment needs, risk tolerance, and

familiarity with capital markets– Identify objectives and constraints– Investment plans are enhanced by accurate

formulation of a policy statement


Summary

• Asset allocation determines long-run returns and risk– Success depends on construction of the policy

statement


The InternetInvestments Online

www.ssa.gov

www.ibbotson.com

www.mfea.com

www.mfea.com/planidx.html

www.asec.com

www.cccsedu.org/home.html

www.aimr.org

www.iafp.org

www.amercoll.edu

www.idfp.org

www.napfa.org

http://www.ssa.gov/

http://www.ibbotson.com/

http://www.mfea.com/

http://www.mfea.com/planidx.html

http://www.asec.com/

http://www.cccsedu.org/home.html

http://www.aimr.org/

http://www.iafp.org/

http://www.amercoll.edu/

http://www.idfp.org/

http://www.napfa.org/


Appendix Chapter 2–Objectives and Constraints of Institutional Investors


Mutual Funds• Legal constraints

• Investment choices by fund managers


Pension Funds• Defined benefit pension plans

–actuarial status

–liquidity constraint

–governed by ERISA


Pension Funds• Defined contribution pension

plans–liquidity and time horizon

–governed by ERISA


Endowment Funds• Charitable or educational

institutions–need for current income

–need for increasing future income


Insurance Companies• Life Insurance Companies

–earn rate in excess of actuarial rate–growing surplus–limited by fiduciary principles–liquidity needs– tax rule changes


Insurance Companies• Nonlife Insurance Companies

–cash flows less predictable–fiduciary responsibility to claimants–liquidity concerns–regulation more permissive


Banks• Must attract funds in a competitive

interest rate environment–tries to maintain a positive difference

between its cost of funds and its return on assets

–liquidity needs–regulatory constraints


End of Chapter 2–The Asset Allocation Decision


Future topicsChapter 3

• Investment choices

• Including global assets in asset allocation decisions

Chapter 2 - The Asset Allocation Decision

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