Chapter 2 The Asset Allocation Decision

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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?

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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
  persons lifetime and circumstances?
• Why do asset allocation strategies differ across
  national boundaries?

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Individual Investor Life Cycle
Net Worth
Figure 2.1
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
Figure 2.2

• 1. Policy statement - Focus Investors
  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 investors needs at
  the minimum risk levels
• 4. Feedback loop Monitor and update investor
  needs, environmental conditions, portfolio
  performance

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Policy Statement

• The Smith Family Portfolios primary focus is the
  production of current income, with long-term
  capital appreciation a secondary consideration.
  The need for a dependable income stream precludes
  investment vehicles with even modest likelihood
  of losses. Liquidity needs reinforce the need to
  emphasize minimum-risk investments. Extensive
  use of short-term investment-grade investments is
  entirely justified by the expectation that a
  low-inflation environment will exist indefinitely
  into the future. For these reasons, investments
  will emphasize U.S. Treasury bills and notes,
  intermediate-term investment-grade corporate
  debt, and select blue chip stocks whose
  dividend distributions are assured and whose
  price fluctuations are minimal.

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

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Investment Constraints

• Liquidity needs
• Time horizon
• Tax concerns
• Interest and dividends
• Capital gain/loss
• Munis -
• Retirement accts (tax deferral)

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Effect of Tax Deferral on Investor Wealth over
Time
Figure 2.5
Investment Value
10,063
5,365
1,000
Time
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Methods of Tax Deferral

• Regular IRA - tax deductible
• withdrawals taxable
• Roth IRA - not tax deductible
• tax-free withdrawals possible
• Annuities
• Employers 401(k) and 403(b) plans

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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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The Effect of Taxes and Inflation on Returns
1981-2004
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Legal and Regulatory Factors

• Limitations or penalties on withdrawals
• Fiduciary responsibilities - prudent man rule
• Investment laws prohibit insider trading

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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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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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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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Historical Average Annual Returns and Return
Variability 1926-2001
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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

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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

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Asset Allocation Strategies

• Integrated asset allocation
• capital market conditions
• investors objectives and constraints
• Strategic asset allocation
• constant-mix
• Tactical asset allocation
• mean reversion
• inherently contrarian
• Insured asset allocation
• constant proportion

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Asset Allocation Strategies

• Selecting an allocation method depends on
• Perceptions of variability in the clients
  objectives and constraints
• Perceived relationship between the past and
  future capital market conditions

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The Importance of Asset Allocation

• Does Asset Allocation Policy Explain 40, 90, or
  100 Percent of Performance?
• Ibbotson and Kaplan FAJ Jan/Feb 2000

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

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Style

• Construct a portfolio to capture one or more of
  the characteristics of equity securities
• Small-capitalization stocks, low-P/E stocks, etc
• Value stocks appear to be underpriced
• price/book or price/earnings
• Growth stocks enjoy above-average earnings per
  share increases

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Does Style Matter?

• Choice to align with investment style
  communicates information to clients
• Determining style is useful in measuring
  performance relative to a benchmark
• Style identification allows an investor to
  diversify by portfolio
• Style investing allows control of the total
  portfolio to be shared between the investment
  managers and a sponsor

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Determining Style

• Style grid
• firm size
• value-growth characteristics
• Style analysis
• constrained least squares

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Benchmark Portfolios

• Sharpe
• T-bills, intermediate-term government bonds,
  long-term government bonds, corporate bonds,
  mortgage related securities, large-capitalization
  value stocks, large-capitalization growth stocks,
  medium-capitalization stocks, small-capitalization
  stocks, non-U.S. bonds, European stocks, and
  Japanese stocks

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Benchmark Portfolios

• Sharpe
• BARRA
• Uses portfolios formed around 13 different
  security characteristics, including variability
  in markets, past firm success, firm size, trading
  activity, growth orientation, earnings-to-price
  ratio, book-to-price ratio, earnings variability,
  financial leverage, foreign income, labor
  intensity, yield, and low capitalization

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Benchmark Portfolios

• Sharpe
• BARRA
• Ibbotson Associates
• simplest style model uses portfolios formed
  around five different characteristics cash
  (T-bills), large-capitalization growth,
  small-capitalization growth, large-capitalization
  value, and small-capitalization value

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Timing Between Styles

• Variations in returns among mutual funds are
  largely attributable to differences in styles
• Different styles tend to move at different times
  in the business cycle

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Value versus Growth

• Growth stocks will outperform value stocks for a
  time and then the opposite occurs
• Over time value stocks have offered somewhat
  higher returns than growth stocks

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Value versus Growth

• Growth-oriented investor will
• focus on EPS and its economic determinants
• look for companies expected to have rapid EPS
  growth
• assumes constant P/E ratio

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Value versus Growth

• Value-oriented investor will
• focus on the price component
• not care much about current earnings
• assume the P/E ratio is below its natural level

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Value and Growth Investing

• Value and Growth Investing Review and Update
• Chan and Lakonishok Financial Analysts Journal
  Jan/Feb 2004