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 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

The Portfolio Management Process 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

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.

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 Total return capital gains and income reinvestment moderate risk exposure

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

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

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

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

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

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

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

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

Historical Average Annual Returns and Return Variability: 1926-2001

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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