1. Chapter 5 INVESTMENT POLICY STATEMENTS AND ASSET ALLOCATION ISSUES

2. Chapter 5 Questions What is asset allocation?What is asset allocation? What are four basic risk management strategies?What are four basic risk management strategies? How and why do investment goals change over a person’s lifetime and circumstances?How and why do investment goals change over a person’s lifetime and circumstances? What are the four steps in the portfolio management process?What are the four steps in the portfolio management process?

3. Chapter 5 Questions Why is a policy statement important to the planning process?Why is a policy statement important to the planning process? What objectives and constraints should be detailed in the policy statement?What objectives and constraints should be detailed in the policy statement? Why is investment education necessary?Why is investment education necessary? What is the role of asset allocation in investment planning?What is the role of asset allocation in investment planning? Why do asset allocation strategies differ across national boundaries?Why do asset allocation strategies differ across national boundaries?

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

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

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

7. Risk Management Strategies Risk TransferRisk 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 ReductionRisk Reduction –Effective diversification and asset allocation strategies can reduce risk, sometimes without sacrificing expected return.

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

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

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

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

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

13. The Portfolio Management Process A four step process: 1.Construct a policy statement 2.Study current financial conditions and forecast future trends 3.Construct a portfolio 4.Monitor needs and conditions

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

15. 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

16. 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

17. 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

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

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

20. 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

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

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

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

24. Investment Constraints Tax ConcernsTax 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 preferencesUnique needs and preferences –Perhaps the investor wishes to avoid types of investments for ethical reasons

25. Investment Education The type of information necessary to construct a good policy statement is neither “common sense” or “common knowledge.”The type of information necessary to construct a good policy statement is neither “common sense” or “common knowledge.” Many investors fail to diversify.Many investors fail to diversify. Many fail to plan completely.Many fail to plan completely. Data indicates that many Americans have greatly under-invested for the future.Data indicates that many Americans have greatly under-invested for the future. The bottom line: If you do not plan for the future, you will likely not be prepared for it.The bottom line: If you do not plan for the future, you will likely not be prepared for it.

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

27. The Importance of Asset Allocation The asset allocation decision (which classes and at what weights) is very important. Using fund data: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.Asset allocation is thus the major factor that drives portfolio risk and return.

28. 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

29. Asset Allocation and Cultural Differences Differences in social, political, and tax environments influence asset allocation.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.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