Analysis of Investments and
Management of Portfolios
by
by Keith
Keith C.
C. Brown
Brown && Frank
Frank K.
K. Reilly
Reilly
The Asset Allocation Decision
–Individual Investor Life Cycle
–The Portfolio Management Process
Chapter 2
–The Need for Policy Statement
–Constructing the Policy Statement
–The Importance of Asset Allocation
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
2-2
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
2-3
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
2-4
Individual Investor Life Cycle
Exhibit 2.2
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
2-7
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
2-8
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
2-9
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?
2-10
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.
2-11
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.
2-12
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
2-13
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.
2-14
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
2-15
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.
2-16
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
2-17
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
2-18
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
2-19
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).
2-20
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.
2-21
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 (85% to
95%) of the overall investment return is due to
the first two decisions, not the selection of
individual investments (see Exhibit 2.8)
2-22
Exhibit 2.8
2-23
The Importance of Asset Allocation
• Investment Returns after Taxes and Inflation
Exhibit 2.9
Compounded Annual Returns: 1981-2007
Before Tax After Taxes After Taxes After
& Inflation & Inflation Inflation
Common Stock 9.41% 6.78% 3.68% 6.31%
LT Gov. Bonds 7.33% 5.28% 2.18% 4.23%
Treasury Bills 5.55% 3.99% 0.89% 2.45%
Municipal Bonds 6.88% 6.88% 3.78% 3.78%
2-24
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
2-25
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
2-26
Asset Allocation Summary
• Asset Allocation and Cultural Differences
– Social, political, and tax environments influence the
asset allocation decision
– Equity allocations of U.S. pension funds average
58%
– In the United Kingdom, equities make up 78% of
assets
– In Germany, equity allocation averages 8%
– In Japan, equities are 37% of assets
– See Exhibits 2.12 and 2.13
2-27
Exhibit 2.12
2-28
Exhibit 2.13
2-29
The Internet Investments Online
• http://www.ssa.gov
• http://ww.ibbotson.com
• http://www.mfea.com/
• http://InvestmentStrategies/Calculators/default.asp
• http://www.asec.org
• http://www.financialengines.com
• http://www.cfainstitute.org
• http://www.troweprice.com
• http://www.theamericancollege.edu
• http://www.cfp.net
• http://www.napfa.org
• http://www.fpanet.org
• http://www.decisioneering.com
2-30
Appendix:
Objectives and Constraints of
Institutional Investors
• Mutual Funds
– Pool investors funds and invests them in financial
assets as per its investment objective
• Endowment Funds
– They represent contributions made to charitable or
educational institutions
2-31
Appendix:
Objectives and Constraints of
Institutional Investors
• Pension Funds
– Receive contributions from the firm, its employees,
or both and invests those funds
– 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
2-32
Appendix:
Objectives and Constraints of
Institutional Investors
• Insurance Companies
– Life Insurance Companies
• earn rate in excess of actuarial rate
• growing surplus if the spread is positive
• fiduciary principles limit the risk tolerance
• liquidity needs have increased
• tax rule changes
2-33
Appendix:
Objectives and Constraints of
Institutional Investors
• Insurance Companies
– Nonlife Insurance Companies
• cash flows less predictable
• fiduciary responsibility to claimants
• Risk exposure low to moderate
• liquidity concerns due to uncertain claim patterns
• regulation more permissive
2-34
Appendix:
Objectives and Constraints of
Institutional Investors
• Banks
– Must attract funds in a competitive interest rate
environment
– Try to maintain a positive difference between their
cost of funds and their return on assets
– Need substantial liquidity to meet withdrawals and
loan demands
– Face regulatory constraints
2-35
