Lecture Presentation Software Chapter 2

to accompany
The Asset Allocation Decision
Investment Analysis and
Questions to be answered:
Portfolio Management
Seventh Edition • What is asset allocation?
by • What are the four steps in the portfolio
Frank K. Reilly & Keith C. Brown management process?
Chapter 2 • 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 2
The Asset Allocation Decision Financial Plan Preliminaries
• What objectives and constraints should Insurance
be detailed in a policy statement?
– Life insurance
• How and why do investment goals change
over a person’s lifetime and • Term life insurance - Provides death
circumstances? benefit only. Premium could change
every renewal period
• Why do asset allocation strategies differ
across national boundaries? • Universal and variable life insurance –
provide cash value plus death benefit

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Financial Plan Preliminaries Financial Plan Preliminaries

Insurance Cash reserve
– Health insurance – To meet emergency needs
– Disability insurance – Includes cash equivalents (liquid
– Automobile insurance investments)
– Home/rental insurance – Equal to six months living expenses
– Liability insurance recommended by experts

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 Individual Investor Individual Investor Life Cycle
Net Worth Exhibit 2.1
Life Cycle
• Accumulation phase – early to middle Accumulation
Phase
Consolidation Phase Spending Phase
Gifting Phase
years of working career Long-term:
Long-term: Retirement Long-term:
• Consolidation phase – past midpoint of Retirement
Short-term:
Estate
careers. Earnings greater than Children’s Planning
college Vacations
expenses Short-term:
Short-term: Children’s College Lifestyle
• Spending/Gifting phase – begins after House Needs Gifts
retirement Car

Age
25 35 45 55 65 75

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Exhibit 2.2

The Portfolio Management Process

Life Cycle Investment Goals
1. Policy statement - Focus: Investor’s short-term and long-
term needs, familiarity with capital market history, and
• Near-term, high-priority goals expectations
2. Examine current and project financial, economic,
political, and social conditions - Focus: Short-term and
• Long-term, high-priority goals intermediate-term expected conditions to use in
constructing a specific portfolio

• Lower-priority goals 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

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The Portfolio Management Process The Portfolio Management Process

1. Policy statement 2. Study current financial and

– specifies investment goals and economic conditions and forecast
acceptable risk levels future trends
– should be reviewed periodically – determine strategies to meet goals
– guides all investment decisions – requires monitoring and updating

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 The Portfolio Management Process The Portfolio Management Process

3. Construct the portfolio 4. Monitor and update

– allocate available funds to minimize – evaluate portfolio performance
investor’s risks and meet investment – Monitor investor’s needs and market
goals conditions
– revise policy statement as needed
– modify investment strategy
accordingly

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Constructing A Policy Statement

The Need For A Policy Statement
• Helps investors understand their own Questions to be answered:
needs, objectives, and investment • What are the real risks of an adverse financial
constraints outcome, especially in the short run?
• Sets standards for evaluating portfolio • What probable emotional reactions will I have to
performance an adverse financial outcome?
• Reduces the possibility of • How knowledgeable am I about investments and
inappropriate behavior on the part of the financial markets?
the portfolio manager

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Constructing A Policy Statement

Investment Objectives
• What other capital or income sources do I
have? How important is this particular • Risk Tolerance
portfolio to my overall financial position? • Absolute or relative percentage
• What, if any, legal restrictions may affect return
my investment needs? • General goals
• What, if any, unanticipated consequences of
interim fluctuations in portfolio value might
affect my investment policy?

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 Investment Objectives Investment Objectives
General Goals
General Goals
• Capital preservation
• Total return
– minimize risk of real loss
– Increase portfolio value by capital gains and by
• Capital appreciation reinvesting current income
– Growth of the portfolio in real terms to meet – Maintain moderate risk exposure
future need
• Current income
– Focus is in generating income rather than
capital gains

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Investment Constraints Investment Constraints

• Liquidity needs • Tax concerns
– Vary between investors depending upon age, – Capital gains or losses – taxed differently from
employment, tax status, etc. income
– Unrealized capital gain – reflect price
• Time horizon appreciation of currently held assets that have
– Influences liquidity needs and risk tolerance not yet been sold
– Realized capital gain – 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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Investment Constraints Equivalent Taxable Yield

• Tax concerns (continued)
– interest on municipal bonds exempt from Municipal Yield
federal income tax and from state of issue ETY =
– interest on federal securities exempt from state 1 − Marginal Tax Rate
income tax
– contributions to an IRA may qualify as
deductible from taxable income
– tax deferral considerations - compounding

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 Effect of Tax Deferral on
Investor Wealth over Time Methods of Tax Deferral
Exhibit 2.6
Investment $10,062.66 • Regular IRA - tax deductible
Value 8% Tax – Tax on returns deferred until withdrawal
Deferred
• Roth IRA - not tax deductible
– tax-free withdrawals possible
$5,365.91 • Cash value life insurance – funds accumulate tax-
5.76%
free until they are withdrawn
After Tax • Tax Sheltered Annuities
Return • Employer’s 401(k) and 403(b) plans – tax-
$1,000
deferred investments
Time
0 10 20 30 years

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Legal and Regulatory Factors Unique Needs and Preferences

• Personal preferences such as socially conscious
• Limitations or penalties on withdrawals investments could influence investment choice
• Fiduciary responsibilities - • Time constraints or lack of expertise for managing
“prudent man” rule the portfolio may require professional
• Investment laws prohibit insider trading management
• Large investment in employer’s stock may require
consideration of diversification needs
• Institutional investors needs

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The Importance
Constructing the Policy Statement
of Asset Allocation
• Objectives - risk and return • An investment strategy is based on four
• Constraints - liquidity, time horizon, tax decisions
factors, legal and regulatory constraints, and – What asset classes to consider for investment
unique needs and preferences – What normal or policy weights to assign to each
• Developing a plan depends on eligible class
understanding the relationship between risk – Determining the allowable allocation ranges
and return and the the importance of based on policy weights
diversification – What specific securities to purchase for the
portfolio

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 The Importance Returns and Risk of Different
of Asset Allocation Asset Classes
• Historically, small company stocks have
• According to research studies, most (85% to generated the highest returns. But the
95%) of the overall investment return is due volatility of returns have been the highest
to the first two decisions, not the selection too
of individual investments • Inflation and taxes have a major impact on
returns
• Returns on Treasury Bills have barely kept
pace with inflation

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Returns and Risk of Different

Asset Allocation Summary
Asset Classes
• Policy statement determines types of assets
• Measuring risk by probability of not to include in portfolio
meeting your investment return objective • Asset allocation determines portfolio return
indicates risk of equities is small and that more than stock selection
of T-bills is large because of their • Over long time periods, sizable allocation to
differences in expected returns equity will improve results
• Focusing only on return variability as a • Risk of a strategy depends on the investor’s
measure of risk ignores reinvestment risk goals and time horizon

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Asset Allocation and

Summary
Cultural Differences
• Identify investment needs, risk tolerance, and
• Social, political, and tax environments influence
familiarity with capital markets
the asset allocation decision
• Identify objectives and constraints
• Equity allocations of U.S. pension funds average
58% • Enhance investment plans by accurate
formulation of a policy statement
• In the United Kingdom, equities make up 78% of
assets • Focus on asset allocation as it determines long-
term returns and risk
• In Germany, equity allocation averages 8%
• In Japan, equities are 37% of assets

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 The Internet Appendix
Investments Online Objectives and Constraints of
www.ssa.gov www.amercoll.edu Institutional Investors
www.ibbotson.com www.idfp.org
www.mfea.com www.napfa.org
• Mutual Funds – pool investors funds and
www.mfea.com/planidx.html
invests them in financial assets as per its
www.asec.com
investment objective
www.cccsedu.org/home.html
www.aimr.org
www.iafp.org

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Pension Funds Endowment Funds

• Receive contributions from the firm, its They represent contributions made to
employees, or both and invests those funds
charitable or educational institutions
• Defined Benefit – promise to pay retirees
a specific income stream after retirement
• Defined Contribution – do not promise a
set of benefits. Employees’ retirement
income is not an obligation of the firm

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Insurance Companies Insurance Companies

• Life Insurance Companies • Nonlife Insurance Companies
– earn rate in excess of actuarial rate – cash flows less predictable
– growing surplus if the spread is positive – fiduciary responsibility to claimants
– Risk exposure low to moderate
– fiduciary principles limit the risk tolerance
– liquidity concerns due to uncertain claim
– liquidity needs have increased patterns
– tax rule changes – regulation more permissive

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 Future topics
Banks Chapter 3
• Must attract funds in a competitive • Investment choices
interest rate environment
• Including global assets in asset
• Try to maintain a positive difference
allocation decisions
between their cost of funds and their
return on assets
• Need substantial liquidity to meet
withdrawals and loan demands
• Face regulatory constraints
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