The Portfolio Management Process

1
The Portfolio Management Process

• 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
  portfolio3. 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

2
Asset Allocation

• The policy statement
• A policy statement specifies the types of risks
  the investor is willing to take and outlines the
  investor's goals and constraints.
• The policy statement is important because it
  provides the investor realistic goals and a
  benchmark for judging the performance of his/her
  portfolio.

3
Asset Allocation

• Inputs to the policy statement
• Goals of the investor
• Recognition of risk
• In order to establish realistic investment goals
  an investor has to understand the risks inherent
  in the investments that are to be made.
• The investor must then assess his/her tolerance
  for risk.
• Peter Lynch says, "Only invest what you could
  afford to lose without that loss having any
  effect on your daily life in the foreseeable
  future." (One Up On Wall Street, p.69)

4
General 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
• Total Return
• Increase portfolio value by capital gains and by
  reinvesting current income
• Maintain moderate risk exposure

5
Asset Allocation

• Inputs to the policy statement
• Long-term vs. short-term goals
• Investment strategies need to be tailored to meet
  both long and short term objectives.
• Risk-tolerance may be different for long and
  short term goals.
• Individual investor lifecycle
• An individual can be though of as passing through
  four stages of an investment life cycle. Each
  stage presents a different set of investor goals
  both for the short term and the long term.

6
Asset Allocation

• Inputs to the policy statement
• Individual investor life cycle
• 1. Pre-investment needs
• Own a house
• Have enough cash to meet basic needs and
  potential unexpected events
• 2. Accumulation phase
• Typically, assets are small relative to
  liabilities
• Short term focus is on accumulating "stuff"
• Long term focus is on retirement and children's
  education

7
Asset Allocation

• Inputs to the policy statement
• Individual investor life cycle
• 3. Consolidation Phase
• Assets begin to grow relative to liabilities
• Children's education moves to short term goal as
  does issues related care for elderly parents.
• Retirement investing is still long term issue.
  However, tolerance for risk may begin to be
  replaced by the need for preservation of capital.
• 4. Spending/Gifting Phase
• Short term goals are focused on lifestyle issues
  and gifting.
• Longer term estate planning begins.

8
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
9
Asset Allocation

• Inputs to the policy statement
• Risk profile of the investor
• There are different "tests" and heuristic
  algorithms that can be used to assess the risk
  preference of an individual.
• A basic test is, " If I invest X, am I willing
  to lose X?"
• Investment constraints
• Liquidity needs
• Time horizon
• Unique needs and preferences
• Stock and option plans
• Tax concerns

10
Asset Allocation

• Inputs to the policy statement
• Investment objectives
• The investor needs to quantify their investment
  goals, given their risk preferences and
  constraints, in terms of a specific risk/return
  objective.
• Benchmark portfolio

11
Asset Allocation

• An investment strategy is based on four decisions
• 1. What asset classes to consider for investment
• 2. What normal or policy weights to assign to
  each eligible class
• 3. Determining the allowable allocation ranges
  based on policy weights
• 4. What specific securities to purchase for the
  portfolio

12
Asset Allocation

• According to research studies, most (85 to 95)
  of the overall investment return is due to the
  first two decisions, not the selection of
  individual investments

13
Asset Allocation

• Why is asset allocation important?
• Different asset classes have different returns
  and risks.
• Investors with long time horizons might suffer
  real losses if equities and long term debt
  instruments are not in their portfolio.
• Investors with short time horizons cannot bear
  the risk of price movements in long term
  securities
• Over time, portfolio returns will be influenced
  more by the asset allocation decision than by our
  allocation of funds within asset classes.

14
Asset Allocation and Cultural Differences

• Social, political, and tax environments influence
  the asset allocation decision
• Equity allocations of U.S. pension funds average
  58
• In the United Kingdom, equities make up 78 of
  assets
• In Germany, equity allocation averages 8
• In Japan, equities are 37 of assets

15
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