chapter number 2

8/11/2019 chapter number 2

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Lecture Presentation Software to accompany

Inv es tm ent A n alys i s an dPo r t fo l io Man ag em en t

Seventh Edition

byFrank K. Reilly & Keith C. Brown

Chapter 2


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Chapter 2The Asset Allocation Decision

Questions to be answered: What is asset allocation?

What are the four steps in the portfoliomanagement process?

What is the role of asset allocation ininvestment planning?

Why is a policy statement important tothe planning process?


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Chapter 2The Asset Allocation Decision

What objectives and constraints shouldbe detailed in a policy statement?

How and why do investment goals changeover a persons lifetime andcircumstances?

Why do asset allocation strategies differacross national boundaries?


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Financial Plan Preliminaries

Insurance Life insurance

Term life insurance - Provides death benefit only. Premium could changeevery renewal period

Universal and variable life insurance provide cash value plus death benefit


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Insurance Health insurance Disability insurance Automobile insurance

Home/rental insurance Liability insurance


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Cash reserve To meet emergency needs Includes cash equivalents (liquid

investments)

Equal to six months living expensesrecommended by experts


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Individual Investor

Life Cycle Accumulation phase early to middleyears of working career

Consolidation phase past midpoint ofcareers. Earnings greater thanexpenses

Spending/Gifting phase begins afterretirement


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Individual Investor Life Cycle

25 35 45 55 65 75

Net Worth

Age

AccumulationPhase

Long-term:Retirement

Childrenscollege

Short-term:HouseCar

Consolidation Phase

Long-term:Retirement

Short-term:

Vacations

Childrens College

Spending PhaseGifting Phase

Long-term:Estate

Planning

Short-term:Lifestyle

Needs Gifts

Exhibit 2.1


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Life Cycle Investment Goals

Near-term, high-priority goals

Long-term, high-priority goals

Lower-priority goals


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The Portfolio Management Process

1. Policy statement - Focus: Investors short -term and long-term needs, familiarity with capital market history, andexpectations

2. Examine current and project financial, economic, political, and social conditions - Focus: Short-term andintermediate-term expected conditions to use inconstructing a specific portfolio

3. Implement the plan by constructing the portfolio - Focus:

Meet the investors needs at the minimum risk levels

4. Feedback loop: Monitor and update investor needs,environmental conditions, portfolio performance

Exhibit 2.2


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1. Policy statement

specifies investment goals andacceptable risk levels should be reviewed periodically

guides all investment decisions


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2. Study current financial and

economic conditions and forecastfuture trends determine strategies to meet goals

requires monitoring and updating


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3. Construct the portfolio

allocate available funds to minimizeinvestors risks and meet investmentgoals


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4. Monitor and update evaluate portfolio performance Monitor investors needs and market

conditions

revise policy statement as needed modify investment strategyaccordingly


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The Need For A Policy Statement

Helps investors understand their ownneeds, objectives, and investment

constraints Sets standards for evaluating portfolio

performance

Reduces the possibility ofinappropriate behavior on the part ofthe portfolio manager


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Constructing A Policy Statement

Questions to be answered: 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 andthe financial markets?


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Constructing A Policy Statement

What other capital or income sources do Ihave? How important is this particular

portfolio to my overall financial position?

What, if any, legal restrictions may affectmy investment needs?

What, if any, unanticipated consequences ofinterim fluctuations in portfolio value mightaffect my investment policy?


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Investment Objectives Risk Tolerance Absolute or relative percentage

return General goals


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Investment ObjectivesGeneral Goals

Capital preservation

minimize risk of real loss Capital appreciation

Growth of the portfolio in real terms to meetfuture need

Current income Focus is in generating income rather than

capital gains


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Investment Objectives

General Goals Total return

Increase portfolio value by capital gains and byreinvesting current income

Maintain moderate risk exposure


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Investment Constraints

Liquidity needs Vary between investors depending upon age,

employment, tax status, etc. Time horizon

Influences liquidity needs and risk tolerance


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Tax concerns Capital gains or losses taxed differently from

income Unrealized capital gain reflect price

appreciation of currently held assets that havenot yet been sold

Realized capital gain when the asset has beensold at a profit Trade-off between taxes and diversification

tax consequences of selling company stock for

diversification purposes


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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


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Equivalent Taxable Yield

RateTaxMarginal1YieldMunicipal

ETY


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Effect of Tax Deferral onInvestor Wealth over Time

0 10 20 30 years

8% TaxDeferred

5.76%

After TaxReturn

$1,000

InvestmentValue

Time

$10,062.66

$5,365.91

Exhibit 2.6


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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 Employers 401(k) and 403(b) plans tax-

deferred investments


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Legal and Regulatory Factors

Limitations or penalties on withdrawals Fiduciary responsibilities -

prudent man rule Investment laws prohibit insider trading


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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 professionalmanagement

Large investment in employers stock may requireconsideration of diversification needs

Institutional investors needs


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Constructing the Policy Statement

Objectives - risk and return Constraints - liquidity, time horizon, tax

factors, legal and regulatory constraints, andunique needs and preferences Developing a plan depends on

understanding the relationship between riskand return and the the importance ofdiversification


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The Importance

of Asset Allocation An investment strategy is based on fourdecisions

What asset classes to consider for investment What normal or policy weights to assign to each

eligible class Determining the allowable allocation ranges

based on policy weights What specific securities to purchase for the

portfolio


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The Importance

of Asset Allocation According to research studies, most (85% to

95%) of the overall investment return is dueto the first two decisions, not the selectionof individual investments


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Returns and Risk of Different

Asset Classes Historically, small company stocks havegenerated the highest returns. But the

volatility of returns have been the highesttoo Inflation and taxes have a major impact on

returns Returns on Treasury Bills have barely kept pace with inflation


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Returns and Risk of Different

Asset Classes Measuring risk by probability of not

meeting your investment return objectiveindicates risk of equities is small and thatof T-bills is large because of theirdifferences in expected returns

Focusing only on return variability as ameasure of risk ignores reinvestment risk


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Asset Allocation Summary

Policy statement determines types of assetsto include in portfolio

Asset allocation determines portfolio returnmore 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


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Asset Allocation and

Cultural Differences Social, political, and tax environments influence

the asset allocation decision

Equity allocations of U.S. pension funds average58%

In the United Kingdom, equities make up 78% ofassets

In Germany, equity allocation averages 8% In Japan, equities are 37% of assets


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Summary

Identify investment needs, risk tolerance, andfamiliarity with capital markets

Identify objectives and constraints Enhance investment plans by accurate

formulation of a policy statement Focus on asset allocation as it determines long-

term returns and risk


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The Internet Investments Online www.ssa.gov

www.ibbotson.com

www.mfea.com www.mfea.com/planidx.html www.asec.com www.cccsedu.org/home.html www.aimr.org

www.iafp.org

www.amercoll.edu www.idfp.org

www.napfa.org
http://www.ssa.gov/http://www.ibbotson.com/http://www.mfea.com/http://www.mfea.com/planidx.htmlhttp://www.asec.com/http://www.cccsedu.org/home.htmlhttp://www.aimr.org/http://www.iafp.org/http://www.amercoll.edu/http://www.idfp.org/http://www.napfa.org/http://www.napfa.org/http://www.idfp.org/http://www.amercoll.edu/http://www.iafp.org/http://www.aimr.org/http://www.cccsedu.org/home.htmlhttp://www.asec.com/http://www.mfea.com/planidx.htmlhttp://www.mfea.com/http://www.ibbotson.com/http://www.ssa.gov/


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Appendix

Objectives and Constraints ofInstitutional Investors

Mutual Funds pool investors funds andinvests them in financial assets as per its

investment objective


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Pension Funds Receive contributions from the firm, its

employees, or both and invests those funds

Defined Benefit promise to pay retireesa specific income stream after retirement

Defined Contribution do not promise aset of benefits. Employees retirementincome is not an obligation of the firm


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Endowment FundsThey represent contributions made to

charitable or educational institutions


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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


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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


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Banks Must attract funds in a competitive

interest rate environment

Try to maintain a positive difference between their cost of funds and theirreturn on assets

Need substantial liquidity to meetwithdrawals and loan demands

Face regulatory constraints


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Future topics

Chapter 3 Investment choices Including global assets in asset

allocation decisions

chapter number 2

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