Chapter 2

The Asset Allocation

Decision
 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
Short-term:
Children’s Planning
college Vacations
Short-term:
Short-term: Children’s College Lifestyle
House Needs Gifts
Car

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 investor’s 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 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
 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
 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
• Assuming portfolio is diversified
 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