2. the asset allocation decision[1]

8/3/2019 2. the Asset Allocation Decision[1]

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Lecture Presentation Softwareto accompany

Investment Analysis and Portfolio Management

Seve nth Editionby

Frank K. R e illy & Ke ith C. Brown

Chapter 2


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Individual InvestorLife Cycle

Accumulation phase early to middleyears of working career Consolidation phase past midpoint of careers. Earnings greater thanexpenses

Spending/Gifting phase begins after retirement


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Individual Investor Life Cycle

25 35 45 55 65 75

N et Worth

Ag e

A ccumulationP h ase

Long-term:Retirement

Ch ildrenscollege

S h ort-term:HouseC ar

C onsolidation P h ase

Long-term:Retirement

S h ort-term:

Vacations

Ch ildrens C ollege

Spending P h aseGifting P h ase

Long-term:Estate

Planning

S h ort-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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Th e 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 marketconditions

revise policy statement as needed modify investment strategy

accordingly


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The Need For A Policy Statement

Helps investors understand their ownneeds, objectives, and investment

constraintsSets standards for evaluating portfolio performanceReduces the possibility of inappropriate behavior on the part of the portfolio manager


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Investment ObjectivesRisk ToleranceAbsolute or relative percentagereturnGeneral goals


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Investment ObjectivesGeneral GoalsCapital preservation

minimize risk of real lossCapital appreciation Growth of the portfolio in real terms to meet

future needCurrent income Focus is in generating income rather than

capital gains


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Investment ObjectivesGeneral GoalsTotal return Increase portfolio value by capital gains and by

reinvesting current income Maintain moderate risk exposure


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Investment ConstraintsLiquidity needs Vary between investors depending upon age,

employment, tax status, etc.Time horizon Influences liquidity needs and risk tolerance


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Investment ConstraintsT ax concerns Capital gains or losses taxed differently from

income Unrealized capital gain reflect priceappreciation 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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Investment ConstraintsTax 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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Legal and Regulatory FactorsLimitations or penalties on withdrawalsFiduciary responsibilities -

prudent man ruleInvestment laws prohibit insider trading


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Unique Needs and PreferencesPersonal preferences such as socially conscious

investments could influence investment choiceTime constraints or lack of expertise for managingthe portfolio may require professionalmanagementLarge investment in employers stock may requireconsideration of diversification needsInstitutional investors needs


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Constructing th

e Policy StatementObjectives - risk and returnConstraints - liquidity, time horizon, tax

factors, legal and regulatory constraints, andunique needs and preferencesDeveloping a plan depends onunderstanding the relationship between risk and return and the the importance of diversification


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Th e Importanceof 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 Determining the allowable allocation ranges

based on policy weights What specific securities to purchase for the

portfolio


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Th e Importanceof Asset Allocation

According to research studies, most (85% to95%) of the overall investment return is dueto the first two decisions, not the selectionof individual investments


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Returns and Risk of DifferentAsset Classes

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

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

returnsReturns on Treasury Bills have barely kept pace with inflation


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Asset Allocation SummaryPolicy statement determines types of assetsto include in portfolio

Asset allocation determines portfolio returnmore than stock selectionOver long time periods, sizable allocation toequity will improve resultsRisk of a strategy depends on the investorsgoals and time horizon

2. the asset allocation decision[1]

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