Chapter 2 The Asset Allocation Decision

1. Chapter 2The 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?

2. Chapter 2The 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?

3. Individual Investor Life Cycle Net Worth Figure 2.1 Accumulation Phase Long-term: Retirement Children’s college Short-term: House Car Consolidation Phase Long-term: Retirement Short-term: Vacations Children’s College Spending Phase Gifting Phase Long-term: Estate Planning Short-term: Lifestyle Needs Gifts Age

4. 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 intermediate-term 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

5. Policy Statement • The Smith Family Portfolio’s primary focus is the production of current income, with long-term capital appreciation a secondary consideration. The need for a dependable income stream precludes investment vehicles with even modest likelihood of losses. Liquidity needs reinforce the need to emphasize minimum-risk investments. Extensive use of short-term investment-grade investments is entirely justified by the expectation that a low-inflation environment will exist indefinitely into the future. For these reasons, investments will emphasize U.S. Treasury bills and notes, intermediate-term investment-grade corporate debt, and select “blue chip” stocks whose dividend distributions are assured and whose price fluctuations are minimal.

6. Standards For Evaluating Portfolio Performance • Benchmark portfolio • risk and return • Matches risk preferences and investment needs • analysis of risk tolerance • return objective goals

7. 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 • Total return • capital gains and income reinvestment • moderate risk exposure

8. Investment Constraints • Liquidity needs • Time horizon • Tax concerns • Interest and dividends • Capital gain/loss • Munis - • Retirement accts (tax deferral)

9. Effect of Tax Deferral on Investor Wealth over Time Figure 2.5 Investment Value $10,063 $5,365 $1,000 Time

10. Methods of Tax Deferral • Regular IRA - tax deductible • withdrawals taxable • Roth IRA - not tax deductible • tax-free withdrawals possible • Annuities • Employer’s 401(k) and 403(b) plans

11. The Effect of Taxes and Inflation on Investment Returns, 1926 - 1998 Figure 2.6 Before Taxes After Taxes After Taxes and Inflation

12. The Effect of Taxes and Inflation on Returns: 1981-2004

13. Legal and Regulatory Factors • Limitations or penalties on withdrawals • Fiduciary responsibilities - “prudent man” rule • Investment laws prohibit insider trading

14. 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

15. 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

16. 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

17. Historical Average Annual Returns and Return Variability: 1926-2001

18. 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

19. 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

20. 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

21. Asset Allocation Strategies • Integrated asset allocation • capital market conditions • investor’s objectives and constraints • Strategic asset allocation • constant-mix • Tactical asset allocation • mean reversion • inherently contrarian • Insured asset allocation • constant proportion

22. Asset Allocation Strategies • Selecting an allocation method depends on: • Perceptions of variability in the client’s objectives and constraints • Perceived relationship between the past and future capital market conditions

23. The Importance of Asset Allocation • Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? • Ibbotson and Kaplan FAJ Jan/Feb 2000

24. 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 • Asset allocation determines long-run returns and risk • Success depends on construction of the policy statement

25. Style • Construct a portfolio to capture one or more of the characteristics of equity securities • Small-capitalization stocks, low-P/E stocks, etc… • Value stocks appear to be underpriced • price/book or price/earnings • Growth stocks enjoy above-average earnings per share increases

26. Does Style Matter? • Choice to align with investment style communicates information to clients • Determining style is useful in measuring performance relative to a benchmark • Style identification allows an investor to diversify by portfolio • Style investing allows control of the total portfolio to be shared between the investment managers and a sponsor

27. Determining Style • Style grid: • firm size • value-growth characteristics • Style analysis • constrained least squares

28. Benchmark Portfolios • Sharpe • T-bills, intermediate-term government bonds, long-term government bonds, corporate bonds, mortgage related securities, large-capitalization value stocks, large-capitalization growth stocks, medium-capitalization stocks, small-capitalization stocks, non-U.S. bonds, European stocks, and Japanese stocks

29. Benchmark Portfolios • Sharpe • BARRA • Uses portfolios formed around 13 different security characteristics, including variability in markets, past firm success, firm size, trading activity, growth orientation, earnings-to-price ratio, book-to-price ratio, earnings variability, financial leverage, foreign income, labor intensity, yield, and low capitalization

30. Benchmark Portfolios • Sharpe • BARRA • Ibbotson Associates • simplest style model uses portfolios formed around five different characteristics: cash (T-bills), large-capitalization growth, small-capitalization growth, large-capitalization value, and small-capitalization value

31. Timing Between Styles • Variations in returns among mutual funds are largely attributable to differences in styles • Different styles tend to move at different times in the business cycle

32. Value versus Growth • Growth stocks will outperform value stocks for a time and then the opposite occurs • Over time value stocks have offered somewhat higher returns than growth stocks

33. Value versus Growth • Growth-oriented investor will: • focus on EPS and its economic determinants • look for companies expected to have rapid EPS growth • assumes constant P/E ratio

34. Value versus Growth • Value-oriented investor will: • focus on the price component • not care much about current earnings • assume the P/E ratio is below its natural level

35. Value and Growth Investing • Value and Growth Investing: Review and Update • Chan and Lakonishok – Financial Analysts Journal Jan/Feb 2004