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Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. Brown. Chapter 2. Chapter 2 The Asset Allocation Decision. Questions to be answered: What is asset allocation? What are the four steps in the portfolio management process?

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investment analysis and portfolio management eighth edition by frank k reilly keith c brown

Investment Analysis and Portfolio ManagementEighth Editionby Frank K. Reilly & Keith C. Brown

Chapter 2

chapter 2 the asset allocation decision
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?
chapter 2 the asset allocation decision1
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?
financial plan preliminaries
Financial Plan Preliminaries

Insurance

  • Life insurance
    • Term life insurance - Provides death benefit only. Premium will change every renewal period
    • Universal and variable life insurance – provide cash value plus death benefit
financial plan preliminaries1
Financial Plan Preliminaries

Insurance

  • Health insurance
  • Disability insurance
  • Automobile insurance
  • Home/rental insurance
  • Liability insurance
financial plan preliminaries2
Financial Plan Preliminaries

Cash reserve

  • To meet emergency needs
  • Includes cash equivalents (liquid investments)
  • Recommendation: Equal to six months living expenses
individual investor life cycle
Individual InvestorLife Cycle
  • Three phases to an Investor’s life cycle:
    • Accumulation phase – early to middle years of working career
    • Consolidation phase – past midpoint of career. Earnings greater than expenses
    • Spending/Gifting phase – begins after retirement
  • Desires & constraints will change as one moves through the different stages
individual investor life cycle1
Individual Investor Life Cycle

Net Worth

Accumulation Phase

Long-term: Retirement Children’s college

Short-term:

House

Car

Consolidation

Phase

Long-term: Retirement

Short-term:

Vacations

Children’s education

Spending Phase Gifting Phase

Long-term: Estate Planning

Short-term: Lifestyle Needs Gifts

Age

life cycle investment goals
Life Cycle Investment Goals
  • Near-term, high-priority goals
  • Long-term, high-priority goals
  • Lower-priority goals
the portfolio management process

Exhibit 2.3

The Portfolio Management Process

1. InvestmentPolicy statement - Focus: Investor’s short-term and long-term needs, familiarity with capital market history, and expectations

2. Examine current and projected 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 with the minimum amount of risk

4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performance

why an investment policy statement
Why An Investment Policy Statement
  • Helps investors understand their own needs, objectives, and investment constraints
  • Sets standards for evaluating portfolio performance
  • Reduces the possibility of inappropriate behavior on the part of the portfolio manager
constructing an investment policy statement
Constructing An Investment Policy Statement

Questions to be answered:

  • What are the risks of an adverse financial outcome, especially in the short run?
  • What emotional reactions will I have to an adverse financial outcome?
  • How knowledgeable am I about investments and the financial markets?
constructing an investment policy statement1
Constructing An Investment 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?
investment objectives
Investment Objectives
  • Return (Absolute or relative percentage return)
  • Risk Tolerance
  • General goals
    • Capital preservation
    • Capital appreciation
    • Income
investment constraints
Investment Constraints
  • Liquidity needs
    • Varies between investors depending upon age, employment, tax status, etc.
  • Time horizon
    • Influences liquidity needs and risk tolerance
investment constraints1
Investment Constraints
  • Tax concerns
    • Capital gains or losses – taxed differently from income
    • Unrealized capital gain – reflect price appreciation of currently held assets that have not yet been sold
    • Realized capital gain – when the asset has been sold at a profit
    • Trade-off between taxes and diversification – tax consequences of selling company stock for diversification purposes
legal and regulatory factors
Legal and Regulatory Factors
  • Limitations or penalties on withdrawals (such as from an RRSP)
  • Fiduciary responsibilities - “prudent person” rule
  • Investment laws prohibit insider trading
unique needs and preferences
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
the importance of asset allocation
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
    • Determining the allowable allocation ranges based on policy weights
    • What specific securities to purchase for the portfolio
the importance of asset allocation1
The Importance of Asset Allocation
  • According to research by Brinson, Hood & Beebower (1986); Brinson, Singer & Beebower (1991) and Ibbotson & Kaplan (2000) most (85% to 95%) of the overall investment return is due to:
    • The choice of asset class
    • The weights allocated to each asset class
returns and risk of different asset classes
Returns and Risk of Different Asset Classes
  • Historically, small company stocks have generated the highest returns. But the volatility of returns have been the highest too
  • Inflation, taxes & expenses have a major impact on realized returns
  • Returns on Treasury Bills have barely kept pace with inflation
returns and risk of different asset classes1
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 that of T-bills is large because of their differences in expected returns
  • Focusing only on return variability as a measure of risk ignores reinvestment risk
asset allocation summary
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, a larger allocation to equity will improve results
  • Risk of a strategy depends on the investor’s goals and time horizon
asset allocation and cultural differences
Asset Allocation and Cultural Differences
  • Social, political, and tax environments influence the asset allocation decision
  • Equity allocations of U.S. pension funds average 58%
  • In the United Kingdom, equities make up 78% of assets
  • In Germany, equity allocation averages 8%
  • In Japan, equities are 37% of assets
asset allocation
Asset Allocation

Source: Benefits Canada http://www.benefitscanada.com/news/article.jsp?content=20060719_114220_4968

summary
Summary
  • Identify investment needs, risk tolerance, and familiarity with capital markets
  • Identify objectives and constraints
  • Enhance investment plans by accurate formulation of an investment policy statement
  • Focus on asset allocation as it largely determines long-term returns and risk
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