The Asset Allocation Decision

What is Asset Allocation?

• Asset Allocation: It is the process of deciding
how to distribute an investor’s wealth among
different countries and asset classes for
investment purposes.
• Asset Class: It refers to the group of securities
that have similar characteristics, attributes, and
risk/return relationships.
• Investor: Depending on the type of investors,
investment objectives and constraints vary
– Individual investors
– Institutional investors
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 Individual Investor Life Cycle
• Financial Plan 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 six months living expenses

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 Individual Investor Life Cycle
• Life Cycle Phases (Exhibit 2.1)
– Accumulation phase: Early to middle years of
working career (Exhibit 2.2)
– Consolidation phase: Past midpoint of careers.
Earnings greater than expenses
– Spending/Gifting phase: Begins after retirement
• Life Cycle Investment Goals
– Near-term, high-priority goals
– Long-term, high-priority goals
– Lower-priority goals
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Exhibit 2.1

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Exhibit 2.2

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 The Portfolio Management Process
• Policy Statement
– Specifies investment goals and acceptable risk levels
– Should be reviewed periodically
– Guides all investment decisions
• Study Current Financial and Economic conditions
and forecast future trends
– Determine strategies to meet goals
– Requires monitoring and updating

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 The Portfolio Management Process
• Construct the Portfolio
– Allocate available funds to minimize investor’s risks and
meet investment goals
• Monitor and Update
– Evaluate portfolio performance
– Monitor investor’s needs and market conditions
– Revise policy statement as needed
– Modify investment strategy accordingly

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The Portfolio Management Process
Exhibit 2.3
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

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 The Need For A 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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The Need For A Policy Statement
• Sets standards for evaluating portfolio
performance
– The statement provides a comparison standard in
judging the performance of the portfolio manager.
– A benchmark portfolio or comparison standard is
used to reflect the risk an return objectives
specified in the policy statement.
– It should act as a starting point for periodic
portfolio review and client communication with the
manager.

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 The Need For A Policy Statement
• Other Benefits
– It helps reduces the possibility of inappropriate or
unethical behavior on the part of the portfolio
manager.
– A clearly written policy statement will help create
seamless transition from one money manager to
another without costly delays.
– It also provides the framework to help resolve any
potential disagreements between the client and
the manager.

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Constructing 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.
• 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
– Risk objective should be based on investor’s
ability to take risk and willingness to take risk.
– 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
– A careful analysis of the client’s risk tolerance
should precede any discussion of return
objectives.

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 Investment Objectives
• Return Objectives
– The return objective may be stated in terms of an
absolute or a relative percentage return.
– Capital Preservation: Minimize risk of real losses
– 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 Needs
– Vary between investors depending upon age,
employment, tax status, etc.
– Planned vacation expenses and house down
payment are some of the liquidity needs.
• Time Horizons
– 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
• Tax Concerns
– Capital gains or losses: Taxed differently from
income
– 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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 Investment Constraints
• Tax concerns (continued)
– Interest on municipal bonds exempt from federal
income tax and from state of issue
Municipal Yield
Equivalent Taxable Yield =
(1 - Marginal Tax Rate)

– Interest on federal securities exempt from state

income tax
– Contributions to an IRA may qualify as deductible
from taxable income
– Tax deferral considerations

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 Methods of Tax Deferral
• Regular IRA
– Tax deductible
– Tax on returns deferred until withdrawal
• Roth IRA
– Not tax deductible
– Tax-free withdrawals possible
• Cash Value Life Insurance
– Funds accumulate tax-free until they are withdrawn
• Tax Sheltered Annuities
• Employer’s 401(k) and 403(b) Plans
– Tax-deferred investments
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 Legal and Regulatory Factors
• Limitations or penalties on withdrawals
• Fiduciary responsibilities
– The “Prudent Investor Rule” normally apply
• Investment laws prohibit insider trading
• Institutional investors deserve special
attentions since legal and regulatory factors
may affect them quite differently (e.g. banks
vs. endowment funds).

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 Unique Needs and 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.
• Large investment in employer’s stock may
require consideration of diversification needs.
• Institutional investors needs.

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The 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
• According to research studies, most (90%) of
the overall investment return is due to the first
two decisions, not the selection of individual
investments (see Exhibit 2.7)
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Exhibit 2.7

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Exhibit 2.8

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The Importance of Asset Allocation
• Returns and Risks of Different Asset Classes
– 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
– 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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