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Chapter 2 The Asset Allocation Decision
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Individual Investor Life Cycle
Exhibit 2.1
Net Worth
Consolidation Phase Long-term
Retirement Short-term Vacations Childrens
College
Accumulation Phase Long-term Retirement
Childrens college Short-term House Car
Spending Phase Gifting Phase Long-term Estate
Planning Short-term Lifestyle Needs Gifts
Age
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The Portfolio Management Process
Exhibit 2.2

• 1. Policy statement (road map)- Focus Investors
  short-term and long-term needs, familiarity with
  capital market history, and expectations
• 2. Examine current and projected 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 investors needs at
  the minimum risk levels
• 4. Feedback loop Monitor and update investor
  needs, environmental conditions, portfolio
  performance

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Input to the policy statement

• Investment objectives expressed in terms of risk
  and return
• Risk Tolerance
• Psychological makeup
• Insurance coverage
• Cash reserves
• Family situation
• Age
• Current net worth
• Income expectations

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• Investment objectives expressed in terms of risk
  and return
• Return objective
• Absolute or relative percentage return
• General goals

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• General Goals
• Capital preservation
• minimize risk of real loss
• Capital appreciation
• Growth of the portfolio in real terms to meet
  future need

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• General Goals
• Total return
• Increase portfolio value by capital gains and by
  reinvesting current income
• Maintain moderate risk exposure
• Income generation
• Focus is in generating income rather than capital
  gains

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Risk Categories and Suggested Asset Allocations
for Merrill Lynch Clients
Exhibit 2.3
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Risk Categories and Suggested Asset Allocations
for Merrill Lynch Clients
Exhibit 2.3
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How Much Risk is Right for You?
Exhibit 2.4
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Investment Constraints

• Liquidity needs
• Vary between investors depending upon age,
  employment, tax status, etc.
• Time horizon
• Influences liquidity needs and risk tolerance
  (longer time horizon faces less liquidity and
  larger risk)

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Investment Constraints

• Tax concerns
• Capital gains/losses or income distributions?
• Unrealized vs realized capital gain
• Trade-off between taxes and diversification (use
  employee payroll deduction plans or 401k to buy
  company stocks)

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Investment Constraints

• 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

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Equivalent Taxable Yield
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Effect of Tax Deferral on Investor Wealth over
Time
Exhibit 2.6
Investment Value
10,062.66
5,365.91
1,000
Time
Marginal tax28, after-tax return5.768
(1-28)
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Methods of Tax Deferral (for US)

• Regular IRA contributions tax deductible
• Tax on returns deferred until withdrawal
• Roth IRA contributions not tax deductible
• tax-free on returns possible
• Cash value life insurance funds accumulate
  tax-free until they are withdrawn
• Tax Sheltered Annuities
• Employers 401(k) and 403(b) plans tax-deferred
  investments

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Historical Average Annual Returns and Return
Variability, 1926-2001
Exhibit 2.9
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Over Long Time Periods, Equities Offer Higher
Returns
Exhibit 2.10
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Returns and Risk of Different Asset Classes

• Historically, small company stocks have generated
  the higher returns. But the volatility of
  returns have been higher too.
• Inflation and taxes have a major impact on
  returns.
• Returns on Treasury Bills have barely kept pace
  with inflation.

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• Extra reading
• Appendix of Chapter 2 Objectives and
  Constraints of Institutional Investors (pages
  63-66)
• Mutual Funds
• Pension funds
• Endowment funds
• Insurance companies
• Banks