Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Sixth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 2
Saif Ullah
Economist_of_Pakistan@Yahoogroups.com
Saifullah271@yahoo.com
+923216633271
Chapter 2
The Asset Allocation Decision
Questions to be answered:
• What is asset allocation?
• What are the four steps in the portfolio
management process?
• What is the role of asset allocation in
investment planning?
• Why is a policy statement important to the
planning process?
Chapter 2
The Asset Allocation Decision
• What objectives and constraints should
be detailed in a policy statement?
• How and why do investment goals
change over a person’s lifetime and
circumstances?
• Why do asset allocation strategies differ
across national boundaries?
Individual Investor
Financial Plan Preliminaries
Insurance
– Life insurance
Individual Investor
Financial Plan Preliminaries
Insurance
– Life insurance
• Term life insurance - death benefit
only, increasing premium at renewal
• Cash value life insurance - death
benefit plus savings plan
Individual Investor
Financial Plan Preliminaries
Insurance
– Health insurance - medial bills
Individual Investor
Financial Plan Preliminaries
Insurance
– Disability insurance - income
Individual Investor
Financial Plan Preliminaries
Insurance
– Property insurance - your home or
automobile
Individual Investor
Financial Plan Preliminaries
Insurance
– Liability insurance - damage to
others or their property
Individual Investor
Financial Plan Preliminaries
Cash reserve
Individual Investor
Financial Plan Preliminaries
Cash reserve
– To meet emergency needs
• Six-month living expense reserve
– Liquid investments
• Easily converted to cash without loss
of value
Individual Investor
Life Cycle
•
•
•
•
Accumulation phase
Consolidation phase
Spending phase
Gifting phase
Individual Investor Life Cycle
Net Worth
Figure 2.1
Accumulation
Phase
Long-term:
Retirement
Children’s college
Short-term:
House
Car
Consolidation Phase Spending Phase
Gifting Phase
Long-term:
Retirement
Long-term:
Estate Planning
Short-term:
Vacations
Children’s College
Short-term:
Lifestyle Needs
Gifts
Age
25
35
45
55
65
75
Life Cycle Investment Goals
• Near-term, high-priority goals
• Long-term, high-priority goals
• Lower-priority goals
Figure 2.2
The Portfolio Management Process
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 intermediateterm 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
The Portfolio Management Process
1. Policy statement
– specifies investment goals and
acceptable risk levels
– should be reviewed periodically
– guides all investment decisions
The Portfolio Management Process
2. Study current financial and
economic conditions and forecast
future trends
– determine strategies to meet goals
– requires monitoring and updates
The Portfolio Management Process
3. Construct the portfolio
– allocate available funds to meet
goals and minimize investor’s risks
The Portfolio Management Process
4. Monitor and update
– revise policy statement as needed
– modify investment strategy
accordingly
– evaluate portfolio performance
The Need For A Policy Statement
• Understand and articulate realistic investor
goals
– needs, objectives, and constraints
– financial markets and risks of investing
Constructing A Policy Statement
• 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
and markets?
Constructing A Policy Statement
• 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 may affect
my investment needs?
• What, if any, unanticipated consequences of
interim fluctuations in portfolio value might
affect my investment policy?
Standards For Evaluating
Portfolio Performance
• Benchmark portfolio
– risk and return
• Matches risk preferences and
investment needs
– analysis of risk tolerance
– return objective goals
Realistic Investor Goals
• Capital preservation
– minimize risk of real loss
– strongly risk-averse or funds needed soon
• Capital appreciation
– capital gains to provide real growth over time for future
need
– aggressive strategy with accepted risk
• Current income
– generate spendable funds
Realistic Investor Goals
• Total return
– capital gains and income reinvestment
– moderate risk exposure
Investment Constraints
• Liquidity needs
– near-term goals
• Time horizon
– longer time horizon favors risk acceptability
– short time horizon favors less risky investments
because losses are harder to overcome in a short
time frame
Investment Constraints
• Tax concerns
– interest and dividends taxed at investor’s
marginal tax rate
– capital gains may be unrealized
– basis and gain or loss realized
– revisions to capital gains tax rates
– tradeoff with diversification needs for
employer’s stock holdings
Investment Constraints
• 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
Equivalent Taxable Yield
Municipal Yield
ETY 
1  Marginal Tax Rate
Effect of Tax Deferral on
Investor Wealth over Time
Figure 2.5
Investment
Value
$10,063
8% Tax
Deferred
$5,365
5.76%
After Tax
Return
$1,000
0
10
20
Time
30 years
Methods of Tax Deferral
• Regular IRA - tax deductible
– withdrawals taxable
• Roth IRA - not tax deductible
– tax-free withdrawals possible
• Cash value life insurance
• Annuities
• Employer’s 401(k) and 403(b) plans
Legal and Regulatory Factors
• Limitations or penalties on withdrawals
• Fiduciary responsibilities “prudent man” rule
• Investment laws prohibit insider trading
Unique Needs and Preferences
• Personal preferences - socially conscious
investments
• Time constraints or expertise for managing the
portfolio may require professional management
• Large investment in employer may require
consideration of diversification needs and
realistic liquidity
• Institutional investors needs
Constructing the Policy Statement
• Objectives - risk and return
• Constraints - liquidity, time horizon, tax
factors, legal and regulatory constraints, and
unique needs and preferences
• Developing a plan depends on understanding
the relationship between risk and return and
the importance of diversification
The Importance
of 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
– The allowable allocation ranges based on policy
weights
– What specific securities to purchase for the
portfolio
The Importance
of Asset Allocation
• Most (85% to 95%) of the overall
investment return is due to the first two
decisions, not the selection of individual
investments
The Effect of Taxes and Inflation on
Investment Returns, 1926 - 1998
Figure 2.6
12
10
8
6
4
Common Stocks
Before
Taxes
After After
Taxes Taxes
and
Inflation
Long-Term
Government
Bonds
Treasury Bills
2
0
-2
Municipal Bonds
Returns and Risk of Different
Asset Classes
• Higher returns compensate for risk
• Policy statements must provide risk
guidelines
• Measuring risk by standard deviation of
returns over time indicates stocks are more
risky than T-bills
Returns and Risk of Different
Asset Classes
• Measuring risk by probability of not meeting
your investment return objective indicates
risk of equities is small and risk of T-bills is
large because of different expected returns
• Focusing only on return variability ignores
reinvestment risk
• Changes in returns from year to year
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
Asset Allocation and
Cultural Differences
• Social, political, and tax environments
• U.S. institutional investors average 45%
allocation in equities
• In the United Kingdom, equities make up
72% of assets
• In Germany, equities are 11%
• In Japan, equities are 24% of assets
Summary
• Develop an investment policy statement
– Identify investment needs, risk tolerance, and
familiarity with capital markets
– Identify objectives and constraints
– Investment plans are enhanced by accurate
formulation of a policy statement
Summary
• Asset allocation determines long-run returns
and risk
– Success depends on construction of the policy
statement
The Internet
Investments Online
www.ssa.gov
www.amercoll.edu
www.ibbotson.com
www.idfp.org
www.mfea.com
www.napfa.org
www.mfea.com/planidx.html
www.asec.com
www.cccsedu.org/home.html
www.aimr.org
www.iafp.org
Appendix Chapter 2
–Objectives and Constraints of
Institutional Investors
Mutual Funds
• Legal constraints
• Investment choices by fund
managers
Pension Funds
• Defined benefit pension plans
–actuarial status
–liquidity constraint
–governed by ERISA
Pension Funds
• Defined contribution pension
plans
–liquidity and time horizon
–governed by ERISA
Endowment Funds
• Charitable or educational
institutions
–need for current income
–need for increasing future
income
Insurance Companies
• Life Insurance Companies
–earn rate in excess of actuarial rate
–growing surplus
–limited by fiduciary principles
–liquidity needs
– tax rule changes
Insurance Companies
• Nonlife Insurance Companies
–cash flows less predictable
–fiduciary responsibility to claimants
–liquidity concerns
–regulation more permissive
Banks
• Must attract funds in a competitive
interest rate environment
–tries to maintain a positive difference
between its cost of funds and its return
on assets
–liquidity needs
–regulatory constraints
End of Chapter 2
–The Asset Allocation Decision
Future topics
Chapter 3
• Investment choices
• Including global assets in asset
allocation decisions