ASSET ALLOCATION

Arief Widijatmoko, SE, MMT, CA, Ak

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The Asset Allocation Decision

Individual Investor Life Cycle

The Portfolio Management Process
The Need for Policy Statement
Constructing the Policy Statement
The Importance of Asset Allocation

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What is Asset Allocation?

 Asset Allocation
 process of deciding how to distribute an investor’s
wealth among different countries and asset
classes for investment purposes
 Asset Class
 group of securities that have similar
characteristics, attributes, and risk/return
relationships

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What is Asset Allocation?

 Investor:
 Depending on the type of investors,
investment objectives and constraints vary
▪ Individual investors
▪ Institutional investors

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Individual Investor Life Cycle: Preliminaries

 Life Insurance: Providing death benefits and,

possibly, additional cash values
▪ Term life and whole life insurance
▪ Universal and variable life insurance
 Non-life Insurance
▪ Health insurance & disability insurance
▪ Automobile insurance & Home/rental insurance
 Cash Reserve
▪ To meet emergency needs
▪ Equal to sixCopyright
months©living expenses
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Phases of an Investor’s Life Cycle
 Accumulation phase
▪ Early to middle years of working career
 Consolidation phase
▪ Past midpoint of careers. Earnings greater than expenses
 Spending/Gifting phase
▪ Begins after retirement

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Phases of an Investor’s Life Cycle

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Life Cycle Investment Goals

 Near-term, high-priority goals

 Long-term, high-priority goals
 Lower-priority goals

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Benefits of Investing Early and Often

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Portfolio Management Process: Policy Statement

 Specifies investment goals and acceptable risk

levels
 Should be reviewed periodically
 Guides all investment decisions

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Portfolio Management Process

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Need for Policy Statement

 Understand investor’s needs and articulate realistic

investment objectives and constraints
 What are the real risks of an adverse financial outcome, and what emotional
reactions will I have?
 How knowledgeable am I about investments and the financial markets?
 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 affect me?
 How would any unanticipated portfolio value change might affect my
investment policy?

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Need for a Policy Statement
 Sets standards for evaluating portfolio performance
 Provides a comparison standard in judging the performance of the
portfolio manager
 Benchmark portfolio or comparison standard is used to reflect the risk an
return objectives specified in the policy statement
 Should act as a starting point for periodic portfolio review and client
communication with the manager

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Need for a Policy Statement

 Other Benefits
 Reduces possibility of inappropriate or unethical behaviour
of the portfolio manager
 Helps create seamless transition from one money
manager to another without costly delays
 Provides the framework to help resolve any potential
disagreements between the client and the manager

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Input to the Policy Statement

 Constructing the policy statement begins with a

profile analysis of the investor’s current and future
financial situations and a discussion of investment
objectives and constraints.

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Input to the Policy Statement

 Objectives
 Risk
 Return
 Constraints
 Liquidity, time horizon, tax factors, legal and
regulatory constraints, and unique needs and
preferences

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Investment Objectives

 Risk Objectives
 Should be based on investor’s ability to take risk
and willingness to take risk

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Investment Objectives

 Risk tolerance depends on an investor’s current

net worth and income expectations and age
▪ More net worth allows more risk taking
▪ Younger people can take more risk
 Careful analysis of client’s risk tolerance should
precede any discussion of return objectives

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Investment Objectives

 Return Objectives
 May be stated in terms of an absolute or a relative
percentage return
 Capital Preservation:
▪ Minimize risk of real losses

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Investment Objectives

 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 with
moderate risk exposure

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Investment Constraints:
Liquidity

 Liquidity
▪ Vary between investors depending upon age,
employment, tax status, etc.
▪ Planned vacation expenses and house down payment
are some of the liquidity needs.

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Investment Constraints:
Time

 Time
▪ Influences liquidity needs and risk tolerance
▪ Longer investment horizons generally requires less
liquidity and more risk tolerance
▪ Two general time horizons are pre-retirement and post-
retirement periods

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Investment Constraints:
Taxes and Interest Income

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Investment Constraints:
Taxes and Interest Income

 Interest Income: 100% of all interest income is taxed at an

investor’s marginal tax rate in Canada.
 Assuming a marginal tax rate of 26%, an investor that
receives $2,000 in interest income will have a $520 tax
liability ($2,000 X 26%)

After Tax Return on Investment (AT -ROI)

AT - ROI = Pre-tax ROI X ( 1 – Marginal Tax Rate)

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 Investment Constraints:
Taxes and Interest Income
 Interest Income: 100% of all interest income is taxed at an
investor’s marginal tax rate in Canada.
 So an investor if you received $2,000 interest income on a
$100,000 investment that would be a 2% ROI on a pre-tax
basis

After Tax Return on Investment (AT -ROI)

AT – ROI = Pre-Tax ROI X ( 1 – Marginal Tax Rate)

AT - ROI = 2% X ( 1 – .26 ) = 1.48%

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Investment Constraints:
Taxes and Dividends

The Dividend Tax Credit Calculation

Dividend Income $2,000
Div. Tax Credit Gross Up (145%) $2,900
Fed. Tax on Grossed Up Div. (26%) $754
($2,900 X 26%)
Fed. Div. Tax on Grossed Up Div. (18.97%) $550
($2,900 X 18.97%)
Net Fed. Taxes on Dividends $204
($754 - $550)
Effective Tax Rate on Dividends 10.20%
($204 ÷ $2,000)
Assuming a marginal tax rate of 26%, the dividend tax credit effectively reduced
the effective tax rate by about 60%

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Investment Constraints:
Taxes and Capital Gains

 Capital gains are also taxed at an effectively lower tax rate because only
50% of a gain is taxed in Canada
Capital Gains Exclusion and Income Taxes
Capital Gain $2,000
Cap. Gains Exclusion Rate (50%) $1,000
(50% X $2,000)
Tax on Taxable Cap. Gains (26%) $260
Effective Tax Rate on Cap. Gains 13%
($260 ÷ $2,000)
Assuming a marginal tax rate of 26%, the effective tax rate on capital gains
is 50% of the marginal rate or in this case 13%.

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Investment Constraints

 Taxes
 Unrealized capital gains: Reflect price appreciation of
currently held assets that have not yet been sold
 Realized capital gains: When the asset has been sold at a
profit
 Trade-off between taxes and diversification: Tax
consequences of selling company stock for diversification
purposes

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Tax Free Investments

 Earn income that is NOT subject to income taxes

 Tax Free Savings Accounts (TSFA)
 tax-free investments

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Legal and Regulatory Constraints

 Limitations or penalties on withdrawals

 Fiduciary responsibilities
 The “Prudent Investor Rule” normally apply
 Investment laws prohibit insider trading

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Legal and Regulatory Constraints

 Institutional investors deserve special

attentions since legal and regulatory factors
may affect them quite differently
 Example: banks vs. endowment funds

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Personal Constraints:
Unique Needs & Preferences

 Personal preferences such as socially

conscious investments could influence
investment choice
 Time constraints or lack of expertise for
managing the portfolio may require
professional management

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Personal Constraints:
Unique Needs & Preferences

 Large investment in employer’s stock may

require consideration of diversification needs
 Institutional investor’s needs

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Importance of Asset Allocation

 Asset Allocation:
 process of deciding how to distribute an investor’s
wealth among different countries and asset
classes for investment purposes

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Importance of Asset Allocation
 An investment strategy is based on four decisions
 What asset classes to consider for investment
 What policy weights to assign to each eligible class
 What allocation ranges are allowed based on policy
weights
 What specific securities to purchase for the portfolio

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Importance of Asset Allocation

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 Importance of 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

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 Importance of Asset Allocation
Historically, small company stocks have generated the
highest returns, so have the volatility
Inflation and taxes have a major impact on returns
Returns on Treasury Bills have barely kept pace with
inflation

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Importance of Asset Allocation

 Measuring risk by the probability of not meeting your investment return objective
indicates risk of equities is small and that of T-bills is large because of their
differences in expected returns
 Focusing only on return variability as a measure of risk ignores reinvestment risk

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 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%

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End of Chapter

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