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
