Chapter 5

THE ASSET ALLOCATION DECISION

Chapter 5 Questions

What is asset allocation?What are four basic risk management strategies?How and why do investment goals change over a person’s lifetime and circumstances?What are the four steps in the portfolio management process?

Chapter 5 Questions

Why is a policy statement important to the planning process?What objectives and constraints should be detailed in the policy statement?Why is investment education necessary?What is the role of asset allocation in investment planning?Why do asset allocation strategies differ across national boundaries?

What is asset allocation?

The process of deciding how to distribute wealth among asset classes, sectors, and countries for investment purposes.

Not an isolated choice, but rather a component of the portfolio management process.

Managing Risk

Since risk drives expected return, investing involves managing risk rather than managing return.

Risk Management Strategies

Risk AvoidanceCan avoid any real chances of lossGenerally a poor strategy except for a part

of an overall portfolio

Risk AnticipationPosition part of your portfolio to protect

against anticipated risk factorsFor example, maintain a cash reserve

Risk Management Strategies

Risk Transfer Insurance and other investment vehicles can allow

for the transfer of risk, often at a price, to another investor who is willing to bear the risk

Risk Reduction Effective diversification and asset allocation

strategies can reduce risk, sometimes without sacrificing expected return.

Individual Investor Life Cycle

The individual investors life cycle can often be described using four separate phases or stages:

Accumulation Phase

Consolidation Phase

Spending Phase

Gifting Phase

Accumulation Phase

Early to middle years of careers

Attempting to satisfy intermediate and long-term goals

Net worth is usually small, debt may be heavy

Long-term investment horizon means usually willing to take moderately high risks in order to make above-average returns

Consolidation Phase

Past career midpointHave paid off much of their accumulated debtEarnings now exceed living expenses, so the balance can be investedTime horizon is still long-term, so moderately high risk investments are still attractive

Spending Phase

Usually begins at retirementSaving before, prudent spending nowLiving expenses covered by Social Security and retirement plansChanging emphasis toward preservation of capital, but still want investment values to keep pace with inflation

Gifting Phase

Can be concurrent with spending phase

If resources allow, individuals can now use excess assets to provide gifts to other individuals or organizations

Estate planning becomes important, especially tax considerations

The Portfolio Management Process

A four step process:

1. Construct a policy statement

2. Study current financial conditions and forecast future trends

3. Construct a portfolio

4. Monitor needs and conditions

The Portfolio Management Process

1. Policy statementSpecifies investment goals and acceptable

risk levelsThe “road map” that guides all investment

decisions

The Portfolio Management Process

2. Study current financial and economic conditions and forecast future trendsDetermine strategies that should meet

goals within the expected environmentRequires monitoring and updates since

financial markets are ever-changing

The Portfolio Management Process

3. Construct the portfolioGiven the policy statement and the

expected conditions, go about investingAllocate available funds to meet goals

while managing risk

The Portfolio Management Process

4. Monitor and updateRevise policy statement as neededMonitor changing financial and economic

conditionsEvaluate portfolio performanceModify portfolio investments accordingly

The Policy Statement

Understand and articulate realistic goalsKnow yourselfKnow the risks and potential rewards from

investments

Learn about standards for evaluating portfolio performanceKnow how to judge average performanceAdjust for risk

The Policy Statement

Don’t try to navigate without a map!

Important Inputs: Investment

Objectives Investment

Constraints

Investment Objectives

Need to specify return and risk objectives Need to consider the

risk tolerance of the investor

Return goals need to be consistent with risk tolerance

Investment Objectives

Possible broad goals:Capital preservationMaintain purchasing powerMinimize the risk of loss

Capital appreciationAchieve portfolio growth through capital

gainsAccept greater risk

Investment Objectives

Current income Look to generate income rather than capital gains May be preferred in “spending phase” Relatively low risk

Total return Combining income returns and reinvestment with

capital gains Moderate risk

Investment Constraints

These factors may limit or at least impact the investment choices:Liquidity needs How soon will the money be needed?

Time horizon How able is the investor to ride out several bad

years?

Legal and Regulatory Factors Legal restrictions often constrain decisions Retirement regulations

Investment Constraints

Tax Concerns Realized capital gains vs. Ordinary income? Taxable vs. Tax-exempt bonds? Regular IRA vs. Roth IRA? 401(k) and 403(b) plans

Unique needs and preferences Perhaps the investor wishes to avoid types of

investments for ethical reasons

Investment Education

The type of information necessary to construct a good policy statement is neither “common sense” or “common knowledge.”Many investors fail to diversify.Many fail to plan completely.Data indicates that many Americans have greatly under-invested for the future.The bottom line: If you do not plan for the future, you will likely not be prepared for it.

Asset Allocation Decisions

Four decisions in an investment strategy:

What asset classes should be considered?

What should be the normal weight for each asset class?

What are the allowable ranges for the weights?

What specific securities should be purchased?

The Importance of Asset Allocation

The asset allocation decision (which classes and at what weights) is very important. Using fund data: About 90% of return variability over time can be

explained by asset allocation. About 40% of the differences between returns can

be explained by differences in asset allocation.

Asset allocation is thus the major factor that drives portfolio risk and return.

Risk/Return History and Asset Allocation

Looking at return data on various asset classes indicate some important factors for investors:Even apparent low-risk investments like T-bills can have considerable reinvestment risk Over long time horizons, stocks have always outperformed low-risk investments. So the additional risk over shorter time horizons seems

to all but disappear over time.

The only way to maintain purchasing power, net of taxes and inflation, is by investing in common stock (see Exhibit 5.11).

Asset Allocation and Cultural Differences

Differences in social, political, and tax environments influence asset allocation.

For instance, 58% of pension fund assets are invested in equities in the U.S. 79% in equities in United Kingdom, where high

average inflation impacts this choice 8% in equities in Germany, where generous

government pensions and greater risk aversion seem to play a strong role