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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


  • 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


  • 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






Long-term: Retirement



Children’s education

Spending Phase Gifting Phase

Long-term: Estate Planning

Short-term: Lifestyle Needs Gifts


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


  • 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