1. INVESTMENT POLICY STATEMENTS AND ASSET ALLOCATION ISSUES
Chapter 4
INVESTMENT POLICY STATEMENTS AND ASSET ALLOCATION ISSUES

2. Chapter 4 Questions What is asset allocation?
What are four basic risk management strategies?
How and why do investment goals change over a person’s lifetime and circumstances?
What are the four steps in the portfolio management process?

3. What is asset allocation?
The process of deciding how to distribute wealth among asset classes, sectors, and countries for investment purposes.
Not an isolated choice, but rather a component of the portfolio management process.

4. Managing Risk
Since risk drives expected return, investing involves managing risk rather than managing return.

5. Risk Management Strategies
Risk Avoidance
Can avoid any real chances of loss
Generally a poor strategy except for a part of an overall portfolio
Risk Anticipation
Position part of your portfolio to protect against anticipated risk factors
For example, maintain a cash reserve

6. Risk Management Strategies
Risk Transfer
Insurance and other investment vehicles can allow for the transfer of risk, often at a price, to another investor who is willing to bear the risk
Risk Reduction
Effective diversification and asset allocation strategies can reduce risk, sometimes without sacrificing expected return.

7. Individual Investor Life Cycle
The individual investors life cycle can often be described using four separate phases or stages:
Accumulation Phase
Consolidation Phase
Spending Phase
Gifting Phase

8. Accumulation Phase Early to middle years of careers
Attempting to satisfy intermediate and long-term goals
Net worth is usually small, debt may be heavy
Long-term investment horizon means usually willing to take moderately high risks in order to make above-average returns

9. Consolidation Phase Past career midpoint
Have paid off much of their accumulated debt
Earnings now exceed living expenses, so the balance can be invested
Time horizon is still long-term, so moderately high risk investments are still attractive

10. Spending Phase Usually begins at retirement
Saving before, prudent spending now
Living expenses covered by Social Security and retirement plans
Changing emphasis toward preservation of capital, but still want investment values to keep pace with inflation

11. Gifting Phase Can be concurrent with spending phase
If resources allow, individuals can now use excess assets to provide gifts to other individuals or organizations
Estate planning becomes important, especially tax considerations

12. The Portfolio Management Process
A four step process:
Construct a policy statement
Study current financial conditions and forecast future trends
Construct a portfolio
Monitor needs and conditions

13. The Portfolio Management Process
1. Policy statement
Specifies investment goals and acceptable risk levels
The “road map” that guides all investment decisions

14. The Portfolio Management Process
2. Study current financial and economic conditions and forecast future trends
Determine strategies that should meet goals within the expected environment
Requires monitoring and updates since financial markets are ever-changing

15. The Portfolio Management Process
3. Construct the portfolio
Given the policy statement and the expected conditions, go about investing
Allocate available funds to meet goals while managing risk

16. The Portfolio Management Process
4. Monitor and update
Revise policy statement as needed
Monitor changing financial and economic conditions
Evaluate portfolio performance
Modify portfolio investments accordingly

17. The Policy Statement Understand and articulate realistic goals
Know yourself
Know the risks and potential rewards from investments
Learn about standards for evaluating portfolio performance
Know how to judge average performance
Adjust for risk

18. The Policy Statement Don’t try to navigate without a map!
Important Inputs:
Investment Objectives
Investment Constraints

19. Investment Objectives
Need to specify return and risk objectives
Need to consider the risk tolerance of the investor
Return goals need to be consistent with risk tolerance
These will change over time

20. Investment Objectives
Possible broad goals:
Capital preservation
Maintain purchasing power
Minimize the risk of loss
Capital appreciation
Achieve portfolio growth through capital gains
Accept greater risk

21. Investment Objectives
Current income
Look to generate income rather than capital gains
May be preferred in “spending phase”
Relatively low risk
Total return
Combining income returns and reinvestment with capital gains
Moderate risk

22. Investment Constraints
These factors may limit or at least impact the investment choices:
Liquidity needs
How soon will the money be needed?
Time horizon
How able is the investor to ride out several bad years?
Legal and Regulatory Factors
Legal restrictions often constrain decisions
Retirement regulations

23. Investment Constraints
Tax Concerns
Realized capital gains vs. Ordinary income?
Taxable vs. Tax-exempt bonds?
Regular IRA vs. Roth IRA?
401(k) and 403(b) plans
Unique needs and preferences
Perhaps the investor wishes to avoid types of investments for ethical reasons

24. Asset Allocation Decisions
Four decisions in an investment strategy:
What asset classes should be considered?
What should be the normal weight for each asset class?
What are the allowable ranges for the weights?
What specific securities should be purchased?

25. The Importance of Asset Allocation
The asset allocation decision (which classes and at what weights) is very important. Using fund data:
About 90% of return variability over time can be explained by asset allocation.
About 40% of the differences between returns can be explained by differences in asset allocation.
Asset allocation is thus the major factor that drives portfolio risk and return.

26. Risk/Return History and Asset Allocation
Looking at return data on various asset classes indicate some important factors for investors:
Over long time horizons, stocks have always outperformed low-risk investments.
So the additional risk of stock investing (higher return standard deviations) over shorter time horizons seems to all but disappear over time.
Need to consider real investment returns over taxes and costs

27. Asset Allocation and Cultural Differences
Differences in social, political, and tax environments influence asset allocation.
For instance, 58% of pension fund assets are invested in equities in the U.S.
78% in equities in United Kingdom, where high average inflation impacts this choice
8% in equities in Germany, where generous government pensions and greater risk aversion seem to play a strong role