Chapter 2 The Asset Allocation Decision

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Chapter 2The Asset Allocation Decision

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Individual InvestorLife Cycle

• Accumulation phase
• Consolidation phase
• Spending phase
• Gifting phase

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

• 1. Policy statement
• specifies investment goals and acceptable risk
  levels
• should be reviewed periodically
• guides all investment decisions

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The Portfolio Management Process

• 2. Study current financial and economic
  conditions and forecast future trends
• determine strategies to meet goals
• requires monitoring and updates

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The Portfolio Management Process

• 3. Construct the portfolio
• allocate available funds to meet goals and
  minimize investors risks

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The Portfolio Management Process

• 4. Monitor and update
• revise policy statement as needed
• modify investment strategy accordingly
• rebalance portfolio
• evaluate portfolio performance

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The Need For A Policy Statement

• Understand and articulate realistic investor
  goals
• needs, objectives, and constraints
• financial markets and risks of investing

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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?

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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?

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Standards For Evaluating Portfolio Performance

• Benchmark portfolio
• risk and return
• Matches risk preferences and investment needs
• analysis of risk tolerance
• return objective goals

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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

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Realistic Investor Goals

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

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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

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Investment Constraints

• Tax concerns
• interest and dividends taxed at investors
  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
  employers stock holdings

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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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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

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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
  importance of diversification

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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

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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
• Assuming portfolio is diversified

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The Effect of Taxes and Inflation on Investment
Returns, 1926 - 1998
Figure 2.6
Before Taxes
After Taxes and Inflation
After Taxes
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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

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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

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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 investors
  goals and time horizon