1. Chapter 2 The Asset Allocation Decision
Zhiqiang Wang
School of Finance
Dongbei University of Finance & Economics
Chapter 2 The Asset Allocation Decision

2. The Asset Allocation Decision
1. Individual Investor Life Cycle
2. The Portfolio Management Process
3. The Need for a Policy Statement
4. Input to the Policy Statement
5. The Importance of Asset Allocation
6. Asset Allocation and Cultural Differences
Chapter 2 The Asset Allocation Decision

3. 1. Individual Investor Life Cycle
The Preliminaries
Life Cycle Net Worth and Investment Strategies
Life Cycle Investment Goals
Chapter 2 The Asset Allocation Decision

4. Individual investor life cycle
Investment needs change over a person’s life cycle.
How individuals structure their financial plans should be related to their age, financial status, future plans, and needs
Pre-investment needs: insurance and cash reserve
Life cycle investment strategies
Life cycle investment goals
Chapter 2 The Asset Allocation Decision

5. Chapter 2 The Asset Allocation Decision
The Preliminaries
Insurance
Cash reserve
Chapter 2 The Asset Allocation Decision

6. Chapter 2 The Asset Allocation Decision
Insurance
Life insurance
Term life insurance - Provides death benefit only. Premium could change every renewal period
Universal and variable life insurance – provide cash value plus death benefit
Health insurance
Disability insurance
Automobile insurance
Home/rental insurance
Liability insurance
Chapter 2 The Asset Allocation Decision

7. Chapter 2 The Asset Allocation Decision
Cash reserve
To meet emergency needs
Includes cash equivalents (liquid investments)
Equal to six months living expenses recommended by experts
Chapter 2 The Asset Allocation Decision

8. Life cycle investment strategies(1)
Accumulation phase
In early-to-middle years of their working careers
Their net worth is small
Making fairly high-risk and long-term investments
Consolidation phase
Past the midpoint of their careers
Earnings exceed expenses
Making moderate-risk and long-term investments
Chapter 2 The Asset Allocation Decision

9. Life cycle investment strategies(2)
Spending phase/Gifting phase
Begins after retirement (Individual retire)
Living expenses are covered by Social Security income and income from prior investments, including employer pension plans
Making less-risk investments
Have sufficient income to cover their expenses
Provide assistance to relatives and friend, etc.
Chapter 2 The Asset Allocation Decision

10. Individual Investor Life Cycle
Net Worth
Exhibit 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
Chapter 2 The Asset Allocation Decision

11. Life cycle investment goals
Near-term, High-priority goals
Shorter-term financial objectives, such as a house down payment
Long-term, High-priority goals
Typically include the ability to retire at a certain age
Lower-priority goals
Not critical, e.g., buying a new car
Chapter 2 The Asset Allocation Decision

12. 2. The Portfolio Management Process
Four steps of the portfolio management process
(1) Policy statement
(2) Examine current financial, economic, political,and social conditions
(3) Implement the plan by constructing the portfolio
(4) Feedback loop
As seen Exhibit 2.2 on next slide
Chapter 2 The Asset Allocation Decision

13. The Portfolio Management Process
Exhibit 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
Chapter 2 The Asset Allocation Decision

14. The Portfolio Management Process
(1) Policy statement
Specifies investment goals and acceptable risk levels
Should be reviewed periodically
Guides all investment decisions
(2) Study current financial and economic conditions and forecast future trends
Determine strategies to meet goals
Requires monitoring and updating
Chapter 2 The Asset Allocation Decision

15. The Portfolio Management Process
(3) Construct the portfolio
Allocate available funds to minimize investor’s risks and meet investment goals
(4) Monitor and update
Evaluate portfolio performance
Monitor investor’s needs and market conditions
Revise policy statement as needed
Modify investment strategy accordingly
Chapter 2 The Asset Allocation Decision

16. 3. The need for a policy statement
Understand and Articulate Investor Goals
Standards for Evaluating Portfolio Performance
Other Benefits
Chapter 2 The Asset Allocation Decision

17. Understand and Articulate Investor Goals
Helps investors understand their own needs, objectives, and investment constraints
An important purpose of writing a policy statement is to help investors understand their needs, objectives, and investment constraints
The policy statement helps the investor to specify realistic goals and become better informed about the risks and costs of investing
Chapter 2 The Asset Allocation Decision

18. Standards for Evaluating Portfolio Performance
Sets standards for evaluating portfolio performance
The policy statement is also the basis for judging the performance of the portfolio manager
Chapter 2 The Asset Allocation Decision

19. Chapter 2 The Asset Allocation Decision
Other Benefits
Reduces the possibility of inappropriate behavior on the part of the portfolio manager
A sound policy statement helps to protect the client against a portfolio manager’s inappropriate investments or unethical behavior
Chapter 2 The Asset Allocation Decision

20. 4. Input to the Policy Statement
Investment Objectives
Investment Constraints
Constructing the Policy Statement
Chapter 2 The Asset Allocation Decision

21. Investment Objectives
Risk Tolerance
Risk categories and suggested asset allocation for Merrill Lynch clients
See Exhibit 2.3 on page 29
Absolute or relative percentage return
General goals
Chapter 2 The Asset Allocation Decision

22. Chapter 2 The Asset Allocation Decision
General goals
Capital preservation
Minimize risk of real loss
Capital appreciation
Growth of the portfolio in real terms to meet future need
Current income
Focus is in generating income rather than capital gains
Total return
Increase portfolio value by capital gains and by reinvesting current income
Maintain moderate risk exposure
Chapter 2 The Asset Allocation Decision

23. Investment Constraints
Liquidity needs
Vary between investors depending upon age, employment, tax status, etc.
Time horizon
Influences liquidity needs and risk tolerance
Tax concerns
Investment planning is complicated by the tax code
Legal and regulatory factors
These factors constraint the investment strategies
Unique needs and preferences
Personal preferences, the time and expertise, etc.
Chapter 2 The Asset Allocation Decision

24. Chapter 2 The Asset Allocation Decision
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
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
Chapter 2 The Asset Allocation Decision

25. Equivalent Taxable Yield
For example
If an investor is in the 28% marginal tax bracket, a taxable yield of 8% has an after-tax yield of 8%(1-28%)=5.76%; an equivalent-risk municipal security offering a yield greater than 5.76% offers the investor greater after-tax returns.
A municipal bond yielding 6% has an equivalent taxable yield of 8.33%= 6%/(1-28%).
Chapter 2 The Asset Allocation Decision

26. Effect of Tax Deferral on Investor Wealth over Time
Exhibit 2.4
Investment Value
$10,062.66
$5,365.91
$1,000
Time
Chapter 2 The Asset Allocation Decision

27. Methods of Tax Deferral
Regular IRA - tax deductible
Tax on returns deferred until withdrawal
Roth IRA - not tax deductible
Tax-free withdrawals possible
Cash value life insurance
Funds accumulate tax-free until they are withdrawn
Tax Sheltered Annuities
Employer’s 401(k) and 403(b) plans
Tax-deferred investments
Chapter 2 The Asset Allocation Decision

28. Legal and Regulatory Factors
Limitations or penalties on withdrawals
Fiduciary responsibilities - “prudent man” rule
Investment laws prohibit insider trading
Chapter 2 The Asset Allocation Decision

29. 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
Institutional investors needs
Chapter 2 The Asset Allocation Decision

30. 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 the importance of diversification
Chapter 2 The Asset Allocation Decision

31. Constructing A Policy Statement
Questions to be answered:
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 the financial markets?
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?
Chapter 2 The Asset Allocation Decision

32. 5. The Importance of Asset Allocation
Real Investment Returns after Taxes and Costs
Returns and Risks of Different Asset Classes
Chapter 2 The Asset Allocation Decision

33. Real Returns and Investment Strategies
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
According to research studies, most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments
See Exhibit 2.5 on page 35
Chapter 2 The Asset Allocation Decision

34. Real Investment Returns after Taxes and Costs
For taxable investments, the only way to maintain purchasing power over time when investing in financial assets is to invest in common stock.
Compound Annual Returns:
Before taxes and inflation
After taxes
After taxes and inflation
Common Stocks
10.7%
7.9%
4.7%
Long-Term Govt. Bonds
5.3%
3.7%
0.6%
Treasury Bills
3.8%
2.7%
-0.4%
Municipal Bond (est.)
6.0%
2.9%
Chapter 2 The Asset Allocation Decision

35. 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. See Exhibit 2.7 on page 38.
Inflation and taxes have a major impact on returns
Returns on Treasury Bills have barely kept pace with inflation. See Exhibit 2.8 on page 39 and 2.9 on page 40.
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
Chapter 2 The Asset Allocation Decision

36. 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
Chapter 2 The Asset Allocation Decision

37. 6. Asset Allocation and Cultural Differences
Although non-US investors make their asset allocation decisions in much the same manner, their allocation decisions will be different from those of US investors because they face different social, economic, political, and tax environments.
National difference in environment can explain much of the divergent portfolio strategies
Chapter 2 The Asset Allocation Decision

38. 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
Chapter 2 The Asset Allocation Decision

39. Chapter 2 The Asset Allocation Decision
Summary
Identify investment needs, risk tolerance, and familiarity with capital markets
Identify objectives and constraints
Enhance investment plans by accurate formulation of a policy statement
Focus on asset allocation as it determines long-term returns and risk
Chapter 2 The Asset Allocation Decision