Chapter 2 The Asset Allocation Decision

Individual Investor Life Cycle

Accumulation phase Consolidation phase Spending phase Gifting phase

Individual Investor Life Cycle

Net Worth
Accumulation Phase Long-term: Retirement Childrens college Short-term: House Car
Figure 2.1

Consolidation Phase Spending Phase Gifting Phase Long-term: Retirement Long-term: Estate Short-term: Planning Vacations Short-term: Childrens College Lifestyle Needs Gifts

Age

25

35

45

55

65

75

The Portfolio Management Process 1. Policy statement

specifies investment goals and acceptable risk levels should be reviewed periodically guides all investment decisions

The Portfolio Management Process 2. Study current financial and economic conditions and forecast future trends
determine strategies to meet goals requires monitoring and updates

The Portfolio Management Process 3. Construct the portfolio

allocate available funds to meet goals and minimize investors risks

The Portfolio Management Process 4. Monitor and update

revise policy statement as needed modify investment strategy accordingly rebalance portfolio 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

Investment Constraints
Tax concerns
interest and dividends taxed at investors 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 employers stock holdings

Investment Constraints
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

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

 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

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 Assuming portfolio is diversified

The Effect of Taxes and Inflation on Investment Returns, 1926 - 1998

12 10 8 6 4 2

Figure 2.6

Before Taxes
After After Taxes Taxes and Inflation

Common Stocks

Long-Term Government Bonds Treasury Bills

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 investors goals and time horizon