Chapter 2 & 3The 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?

Financial Plan Preliminaries

Insurance– Life insurance

• Term life insurance - Provides death benefit only. Premium could change every renewal period

• Universal and variable life insurance – provide cash value plus death benefit

Financial Plan Preliminaries

Insurance– Health insurance

– Disability insurance

– Automobile insurance

– Home/rental insurance

Financial Plan Preliminaries

Cash reserve– To meet emergency needs

– Includes cash equivalents (liquid investments)

– Equal to six months living expenses recommended by experts

Individual InvestorLife Cycle

• Accumulation phase – early to middle years of working career

• Consolidation phase – past midpoint of careers. Earnings greater than expenses

• Spending/Gifting phase – begins after retirement

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

Exhibit 2.1

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

Exhibit 2.2

The Portfolio Management Process

1. Policy statement– specifies investment goals and

acceptable risk levels

– should be reviewed periodically

– guides all investment decisions

The Portfolio Management Process

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

– requires monitoring and updating

The Portfolio Management Process

3. Construct the portfolio– allocate available funds to minimize

investor’s risks and meet investment goals

The Portfolio Management Process

4. Monitor and update– evaluate portfolio performance– Monitor investor’s needs and market

conditions– revise policy statement as needed– modify investment strategy

accordingly

The Need For A Policy Statement

• Helps investors understand their own needs, objectives, and investment constraints

• Sets standards for evaluating portfolio performance

• Reduces the possibility of inappropriate behavior on the part of the portfolio manager

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?

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?

Investment ObjectivesGeneral Goals

• Capital preservation– minimize risk of real loss

• Capital appreciation– Growth of the portfolio in real terms to meet

future need

• Current income– Focus is in generating income rather than capital

gains

Investment Objectives

General Goals• Total return

– Increase portfolio value by capital gains and by reinvesting current income

– Maintain moderate risk exposure

Investment Constraints

• Liquidity needs– Vary between investors depending upon age,

employment, tax status, etc.

• Time horizon– Influences liquidity needs and risk tolerance

Investment Constraints

• Tax concerns– Capital gains or losses – taxed differently from

income– Unrealized capital gain – reflect price

appreciation of currently held assets that have not yet been sold

– Realized capital gain – when the asset has been sold at a profit

Legal and Regulatory Factors

• Limitations or penalties on withdrawals

• Investment laws prohibit insider trading

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

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– Determining the allowable allocation ranges

based on policy weights– What specific securities to purchase for the

portfolio

Returns and Risk of Different Asset Classes

• Historically, small company stocks have generated the highest returns. But the volatility of returns have been the highest too

• Inflation and taxes have a major impact on returns

• Returns on Treasury Bills have kept pace with inflation

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

Summary

• Identify investment needs, risk tolerance, and familiarity with capital markets

• Identify objectives and constraints• Enhance investment plans by accurate

formulation of a policy statement• Focus on asset allocation as it determines long-

term returns and risk

Chapter 3 – Selecting Investments in a

Global Market

Questions to be answered:

• Why should investors have a global perspective regarding their investments?

Reasons for the expansion of investment opportunities

1. Growth and development of foreign financial markets

2. Advances in telecommunications technology

3.  Mergers of firms and security exchanges

The Case for Constructing Global Investment Portfolios

1. Ignoring foreign markets can substantially reduce the investment choices for investors

2. The rates of return on foreign securities often have substantially exceeded those for home country

3. The low correlation between domestic stock markets and many foreign markets can help to substantially reduce portfolio risk

Relative Size of U.S. Financial Markets

1. The share of the U.S. in world capital markets has dropped from about 65 percent of the total in 1969 to about 48 percent in 2000

2. The growing importance of foreign securities in world capital markets is likely to continue

Global Bond Portfolio Risk

1. Macroeconomic differences cause the correlation of bond returns between the home and foreign countries to differ

2. The correlation of returns between a single pair of countries changes over time because the factors influencing the correlation change over time

Risk of Combined Country Investments

• Diversified portfolios reduce variability of

returns over time

• Correlation coefficients measure diversification

contribution

• Compare correlation of return among domestic

bonds and stocks with returns on foreign bonds

and stocks

Global Bond Portfolio Risk• Low positive correlation

• Opportunities for investors to reduce risk

• Correlation changes over time

• Adding non-correlated foreign bonds to a portfolio of local bonds increases the rate of return and reduces the risk of the portfolio

Global Equity Portfolio Risk

• Low positive correlation

• Opportunities to reduce risk of stock

portfolio by including foreign stocks

Summary on Global Investing

• Relatively high rates of return

combined with low correlation

coefficients indicate that adding foreign

stocks and bonds to a local portfolio

will reduce risk and may increase its

average return

Global Investment Choices• Fixed-income investments

– bonds and preferred stocks

• Equity investments• Special equity instruments

– options

• Futures contracts• Investment companies• Real assets

Fixed-Income Investments• Contractual payment schedule• Recourse varies by instrument• Bonds

– investors are lenders– expect interest payment and return of

principal

• Preferred stocks– dividends require board of directors approval

Savings Accounts• Fixed earnings• Convenient• Liquid• Low risk• Low rates

Municipal Bonds• Issued by state and local governments

usually to finance infrastructural projects.

• Exempt from taxation by the federal

government and by the state that issued the

bond, provided the investor is a resident of

that state

Corporate Bonds

• Issued by a corporation

• Fixed income

• Credit quality measured by ratings

• Maturity

• Features

– Indenture

– Call provision

– Sinking fund

Preferred Stock

• Fixed dividends• Dividend obligations are not legally

binding, but must be voted on by the board of directors to be paid

• Most preferred stock is cumulative• Credit implications of missing dividends

International Bond Investing

Investors should be aware that there is a very substantial fixed income market outside the home country that offers additional opportunity for diversification

International Bond Investing

• Bond identification characteristics– Country of origin

– Location of primary trading market

– Home country of the major buyers

– Currency of the security denomination

• Eurobond– An international bond denominated in a currency

not native to the country where it is issued

Equity Investments

• Returns are not contractual and may be better or worse than on a bond

Equity Investments

Common Stock– Represents ownership of a firm

– Investor’s return tied to performance of the company and may result in loss or gain

Special Equity Instruments• Equity-derivative securities have a claim on

common stock of a firm

• Options are rights to buy or sell at a stated price for a period of time

• Puts are options to sell to an investor

• Calls are options to buy from a stockholder

Futures Contracts

• Exchange of a particular asset at a specified delivery date for a stated price paid at the time of delivery

• Deposit is made by buyer at contract to protect the seller

• Commodities trading is largely in futures contracts

• Current price depends on expectations

Financial Futures• Recent development of contracts on financial

instruments such as T-bills, Treasury bonds, and Eurobonds

• Traded mostly on Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT)

• Allow investors and portfolio managers to protect against volatile interest rates

• Currency futures allow protection against changes in exchange rates

Investment Companies• Rather than buy individual securities

directly from the issuer they can be acquired indirectly through shares in an investment company

• Investment companies sell shares in itself and uses proceeds to buy securities

• Investors own part of the portfolio of investments

Real Estate Investment Trusts (REITs)

• Investment fund that invests in a variety of real estate properties

• Construction and development trusts provide builders with construction financing

• Mortgage trusts provide long-term financing for properties

• Equity trusts own various income-producing properties

Antiques

• Dealers buy at estate sales, refurbish, and sell at a profit

• Serious collectors may enjoy good returns

• Individuals buying a few pieces to decorate a home may have difficulty overcoming transaction costs to ever enjoy a profit

Art

• Investment requires substantial knowledge of art and the art world

• Acquisition of work from a well-known artist requires large capital commitments and patience

• High transaction costs

• Uncertainty and illiquidity

Coins and Stamps• Enjoyed by many as hobby and as an

investment• Market is more fragmented than stock

market, but more liquid than art and antiques markets

• Price lists are published weekly and monthly

• Grading specifications aid sales• Wide spread between bid and ask prices

Diamonds

• Can be illiquid

• Grading determines value, but is subjective

• Investment-grade gems require substantial investments

• No positive cash flow until sold

• Costs of insurance, storage, and appraisal

Returns of Stocks, Bonds, and T-Bills• Ibbotson and Sinquefield (I&S) examined nominal and

real rates of return for seven major classes of assets in the United States– 1. Large-company common stocks– 2. Small-capitalization common stocks– 3. Long-term U.S. government bonds– 4. Long-term corporate bonds– 5. Intermediate-term U.S. Treasury bills– 6. U.S. Treasury bills– 7. Consumer goods (inflation)

Returns of Stocks, Bonds, and T-Bills

• Returns and risk increase together

• Rates of return are generally consistent with

the uncertainty of returns

World Portfolio Performance• Ibbotson, Siegel, and Love examined the

performance of assets around the world

• Asset return and risk relationship is confirmed

• Coefficients of variation range widely, showing benefits of global diversification

• Correlations between asset returns vary by global regions

Art and Antiques• Market data is limited

• Results vary widely, and change over time, making generalization impossible, but showing a reasonably consistent relationship between risk and return

• Correlation coefficients vary widely, allowing for great diversification potential

• Liquidity is still a concern

Real Estate• Returns are difficult to derive due to lack of

consistent data

• Residential shows lower risk and return than commercial real estate

• During some short time periods REITs have shown higher returns than stock with lower risk measures

• Long term returns for real estate are lower than stocks, and have lower risk

Real Estate

• Negative correlation between residential

and farm real estate and stocks

• Low positive correlation between

commercial real estate and stocks

• Potential for diversification

AppendixCovariance and Correlation

Covariance• absolute measure of the

extent to which two sets of numbers move together over time

Covariance N

jjiiij

COV

then,j as )j-(j and i as )i-(i define weIf

N

jiij

COV

Correlation• relative measure of a

given relationship

Correlation

ji

ijijr

COV

N

iii

2