UNIT 2
The Asset Allocation Decision
Overview
This Unit will examine the factors contributing to investment decisions. Chapter 1 introduced
us to Mike, a young professional who is starting his investment portfolio. We also examined the
connection between risk and return and the importance of managing risk and return. In this
unit, we will explore the portfolio management process, that is, the steps involved in deriving
an investment strategy. We will examine the importance of setting investment goals and
objectives in order to increase the probability of success overtime.
This Unit will first define the Investor Lifecycle, and illustrate how goals and objectives change
over an individual's lifetime. This will lead into the four step portfolio management process and
the construction of a policy statement, which outlines the investment objectives and constraints.
The Unit will conclude by demonstrating how setting investment goals and objectives
determines the distribution of investors' wealth.
Unit 1 Learning Objectives
At the end of this unit students should be able to:
 Outline the asset allocation process.
 Contribute to the construction of a Policy Statement based on an assessment of given
individual needs.
This Unit is divided into three sessions as follows:
Session 2.1:
The Investor Life Cycle
Session 2.2:
Portfolio Management Process
Session 2.3:
Policy Statement
Session 2.4:
Asset Allocation
Reading Resources
Required Reading
Faure, P. D. (2013). Four phases of the life-cycle. In Investments: An Introduction (pp. 7-33).
Quoin Institue Ltd.
http://bookboon.com/en/investments-an-introduction-ebook
Session 2.1
The Investor Life Cycle
Introduction
An individual's needs and wants change over time, a person's demands at 25 will change as
their circumstances change. Therefore, their financial planning will also adjust to meet these
needs. This Unit will examine each phase of an investor's life and illustrate how their
investment decisions will amend to meet these needs.
Session 2.1 Objectives
On completion of this session, you will be able to:

Demonstrate knowledge of how investment goals changes over a person's life cycle

Assess asset allocation strategies that can be applied at each phase
The Individual Investor Life Cycle
View the following resource on the Investment Life Cycle
Investment Life Cycle
https://www.youtube.com/watch?v=v4zr-rJbEj4
As an individual moves from early career to retirement, financial planning and status will
adjust to suit the individual's needs. The video above provides an overview of the investment
lifecycle. This can be illustrated as below:
(Reilly & Brown, Investment Analysis and Portfolio Management, 2012)
The three phases of the investment lifecycle are:
1. The accumulation phase is defined as the early-to-mid-years of career.
2. Consolidation phase: Past midpoint of careers. Earnings greater than expenses
3. Spending/Gifting phase: Begins after retirement
Investment goals change as an individual transitions from phase to phase. Mike from Unit 1 for
example will be in the accumulation phase, as defined by his age and stage in his career. Thus,
his focus will be to satisfy his immediate needs. It is expected that his net worth will be small,
and his debt may be heavy. Mike is in a healthy position to hold securities for the long run i.e.
his investment horizon is long term; therefore, he might be willing to take moderately high risks
in order to make above average returns.
As Mike transitions to the Consolidation Phase in his mid-thirties, it is expected that he would
have paid off most of his outstanding debt, and his earning will then safely exceed his expenses.
Thee investment horizon is still relatively long, so moderately high risk investments are still
attractive. The Consolidation Phase lasts from mid-thirties until retirement, when the Spending
and Gifting Phase begins.
In retirement living expenses are covered by retirement plans, pension and other prior
investments. The overall investment portfolio in this phase will be less risky, but still require
growth investments.
Learning Activity 2.1
How would the investment advice you give your 24 year old cousin differ
from the investment advice you give you 68 year old grandmother? What
accounts for these differences?
Session Summary
Now that we have examined how investors' needs change over their lifetime, we can now
examine the process of analysing the investment portfolio in each stage. The following session
will walk through the four stages of the portfolio management process.
Session 2.2
The Portfolio Management Process
Introduction
Portfolio Managers follow a four step process in order to decide how to distribute an Investor's
assets. This involves first examining the needs of the Investor, then the environment under
which the investments take place, followed by the implementation of the investment strategy
and the continuous evaluation and analysis of the portfolio.
Session 2.2 Objectives
At the end of this session, you will be able to:

Explain the four steps of the portfolio management process
The Portfolio Management Process
Session Summary
The four step management process provides a framework for assessing the investor's needs and
establishing a strategy to ensuring that these needs are met. In the next session we will examine
the foundation of this process, the policy statement.
Session 2.3
The Policy Statement
“A goal without a plan is just a wish.”
― Antoine de Saint-Exupéry
Introduction
A policy statement provides a road map for achieving the investor's goals. The policy statement
guides the portfolio manager towards meeting the investor's needs by laying out the goals,
constraints and risk appetite of the investor. Given this Information, the portfolio manager will
be able to make educated investment decisions on the Investor's behalf.
Session 2.3
On completion of this session you will be able to:
 Outline the steps involved in constructing a policy statement
 Identify the critical components of policy statement
 Assess the usefulness of a policy statement in the planning process
The Need for a Portfolio Statement
1. 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. 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.
3. 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.
Constructing the Portfolio 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, and any
unique needs the investor might be faced with.
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.
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
Risk Objectives
Investment Constraints
The following factors might place limits on the investor's ability to take maximum risks on their
investments:
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.

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
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.
USEFUL RESOURCES
The following resource provides information on the components of a policy
statement.
Elements of an Investment Policy Statement for Individual Investors:
http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2010.n12.1
Session Summary
Setting the ground for investment decisions, the portfolio manager can now distribute the assets
of the investor among the various investment tools available in the market. In the next session,
we will conclude the unit by exploring this process.
Session 2.4
The Asset Allocation Process
Introduction
Once a policy statement and an investment strategy have been established, the portfolio
manager can now distribute the investor's wealth in order to balance risk and returns i.e. Asset
Allocation.
Session Objectives
At the end of this session, you will be able to:
- Explain the importance of asset allocation strategies
The Importance of 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.
An investment strategy is based on four decisions
1. What asset classes to consider for investment
2. What policy weights to assign to each eligible class
3. What allocation ranges are allowed based on policy weights
4. What specific securities to purchase for the portfolio
USEFUL RESOURCES
The following resources provide information on the asset allocation decision:
Asset Allocation-http://www.investopedia.com/terms/a/assetallocation.asp
The Asset Allocation Decision:
http://investorsolutions.com/our-books/investment-strategies-for-the-21st-century/chapter-6the-asset-allocation-decision/
Learning Activity 2.2
Use the Internet to find home pages for some financial-planning firms. What
strategies do they emphasize? What do they say about their asset allocation
strategy? What are the firms’ emphases- for example value investing,
international diversification principal preservation, retirement and estate
planning?
Session Summary
The asset allocation process does more than determine which assets the investor should invest
in, it directly affects the portfolio return. The selection of specific investment assets reflects the
investor's goals and time horizon as determined through the previous stages of the portfolio
management process.
Unit 2 Summary
Unit 2 highlighted the relationship between the investor and the portfolio manager. In this unit
we established the importance of setting investment goals, while considering Investment
constraints via the construction of a policy statement and investment plan. We also reviewed
the importance of the asset allocation decision.
References
Faure, P. D. (2013). Four phases of the life-cycle. In Investments: An Introduction (pp. 7-33).
Quoin Institue Ltd.
http://bookboon.com/en/investments-an-introduction-ebook