Chapter 2 The Asset Allocation Decision

Lecture Presentation Software
to accompany
Investment Analysis and

Portfolio Management
Sixth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 2
Saif Ullah
Economist_of_Pakistan@Yahoogroups.com
Saifullah271@yahoo.com
+923216633271
Chapter 2
The 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?
SAIF ULLAH, Saifullah271@yahoo.com, +923216633271
Chapter 2
The 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?

Individual Investor
Financial Plan Preliminaries
Insurance
– Life insurance

Individual Investor
Insurance
– Life insurance
• Term life insurance - death benefit
only, increasing premium at renewal
• Cash value life insurance - death
benefit plus savings plan

Individual Investor
Insurance
– Health insurance - medial bills

Individual Investor
Insurance
– Disability insurance - income

Individual Investor
Insurance
– Property insurance - your home or
automobile

Individual Investor
Insurance
– Liability insurance - damage to
others or their property

Individual Investor
Cash reserve

Individual Investor
Cash reserve
– To meet emergency needs
• Six-month living expense reserve
– Liquid investments
• Easily converted to cash without loss
of value

Individual Investor
Life Cycle
• Accumulation phase
• Consolidation phase
• Spending phase
• Gifting phase

Individual Investor Life Cycle
Net Worth Figure 2.1
Accumulation Consolidation Phase Spending Phase

Phase Gifting Phase
Long-term:
Long-term: Retirement Long-term:
Retirement Estate Planning
Short-term:
Children’s college
Short-term:
Vacations
Short-term: Lifestyle Needs
House Children’s College Gifts
Car
Age
25 35 45 55 65 75
Life Cycle Investment Goals
• Near-term, high-priority goals
• Long-term, high-priority goals
• Lower-priority goals

Figure 2.2
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

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

2. Study current financial and

economic conditions and forecast
future trends
– determine strategies to meet goals
– requires monitoring and updates

3. Construct the portfolio

– allocate available funds to meet
goals and minimize investor’s risks

4. Monitor and update

– revise policy statement as needed
– modify investment strategy
accordingly
– evaluate portfolio performance

The Need For A Policy Statement
• Understand and articulate realistic investor

goals
– needs, objectives, and constraints
– financial markets and risks of investing

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?

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?

Standards For Evaluating
Portfolio Performance
• Benchmark portfolio
– risk and return
• Matches risk preferences and
investment needs
– analysis of risk tolerance
– return objective goals

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
Realistic Investor Goals
• Total return
– capital gains and income reinvestment
– moderate risk exposure

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

• Tax concerns
– interest and dividends taxed at investor’s
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
employer’s stock holdings

• 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

Equivalent Taxable Yield
Municipal Yield
ETY =
1 − Marginal Tax Rate

Effect of Tax Deferral on
Investor Wealth over Time
Figure 2.5
Investment $10,063
Value 8% Tax
Deferred
$5,365
5.76%
After Tax
Return
$1,000
Time
0 10 20 30 years
Methods of Tax Deferral
• Regular IRA - tax deductible
– withdrawals taxable
• Roth IRA - not tax deductible
– tax-free withdrawals possible
• Cash value life insurance
• Annuities
• Employer’s 401(k) and 403(b) plans

Legal and Regulatory Factors
• Limitations or penalties on withdrawals
• Fiduciary responsibilities -
“prudent man” rule
• Investment laws prohibit insider trading

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
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

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
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

The Effect of Taxes and Inflation on
Investment Returns, 1926 - 1998
Figure 2.6
12
Common Stocks
Before
10
Taxes
8
After After
Taxes Taxes Long-Term
and Government
6 Bonds
Inflation
4 Treasury Bills
2
Municipal Bonds
0
-2
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

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

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
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

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

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

The Internet
Investments Online
www.ssa.gov www.amercoll.edu
www.ibbotson.com www.idfp.org
www.mfea.com www.napfa.org
www.mfea.com/planidx.html
www.asec.com
www.cccsedu.org/home.html
www.aimr.org
www.iafp.org
Appendix Chapter 2
–Objectives and Constraints of
Institutional Investors

Mutual Funds
• Legal constraints
• Investment choices by fund
managers

Pension Funds
• Defined benefit pension plans
–actuarial status
–liquidity constraint
–governed by ERISA

Pension Funds
• Defined contribution pension
plans
–liquidity and time horizon
–governed by ERISA

Endowment Funds
• Charitable or educational
institutions
–need for current income
–need for increasing future
income
Insurance Companies
• Life Insurance Companies
– earn rate in excess of actuarial rate
– growing surplus
– limited by fiduciary principles
– liquidity needs
– tax rule changes

Insurance Companies
• Nonlife Insurance Companies
– cash flows less predictable
– fiduciary responsibility to claimants
– liquidity concerns
– regulation more permissive

Banks
• Must attract funds in a competitive
interest rate environment
– tries to maintain a positive difference
between its cost of funds and its return
on assets
– liquidity needs
– regulatory constraints
End of Chapter 2
–The Asset Allocation Decision

Future topics
Chapter 3
• Investment choices
• Including global assets in asset
allocation decisions

Chapter 2 The Asset Allocation Decision

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Investment Analysis and

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Accumulation Consolidation Phase Spending Phase

• Near-term, high-priority goals

• Long-term, high-priority goals

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

The Portfolio Management Process

4. Feedback loop: Monitor and update investor needs,

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

2. Study current financial and

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

3. Construct the portfolio

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

4. Monitor and update

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

• Understand and articulate realistic investor

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

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