1. Investment Analysis and Portfolio Management Eighth Edition by Frank K
Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. Brown
Chapter 2

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?
What is the role of asset allocation in investment planning?
Why is a policy statement important to the planning process?

3. 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?

4. 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

5. Financial Plan Preliminaries
Insurance
Health insurance
Disability insurance
Automobile insurance
Home/rental insurance
Liability insurance

6. Financial Plan Preliminaries
Cash reserve
To meet emergency needs
Includes cash equivalents (liquid investments)
Recommendation: Equal to six months living expenses

7. Individual Investor Life 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
Analyzing data from a 2004 national survey on the first wave of baby boomers, Lusardi and Mitchell found that those who did "a lot" of retirement preparation had a median net worth of $200,000, compared with $84,000 for those who did the least.
Source:

8. 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

9. Life Cycle Investment Goals
Near-term, high-priority goals
Long-term, high-priority goals
Lower-priority goals

10. The Portfolio Management Process
Exhibit 2.3
The Portfolio Management Process
1. Investment Policy 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

11. 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

12. 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?

13. 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?

14. Investment Objectives
Return (Absolute or relative percentage return)
Risk Tolerance
General goals
Capital preservation
Capital appreciation
Income

15. Investment Constraints
Liquidity needs
Varies between investors depending upon age, employment, tax status, etc.
Time horizon
Influences liquidity needs and risk tolerance

16. 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

17. Legal and Regulatory Factors
Limitations or penalties on withdrawals (such as from an RRSP)
Fiduciary responsibilities - “prudent person” rule
Investment laws prohibit insider trading

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. Asset Allocation
Source: Benefits Canada

26. 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