1. Chapter 2

2. 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? Copyright © 2000 by Harcourt, Inc. All rights reserved.

3.  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? Copyright © 2000 by Harcourt, Inc. All rights reserved.

4. Insurance  Life insurance Term life insurance - death benefit only, increasing premium at renewal Cash value life insurance - death benefit plus savings plan Copyright © 2000 by Harcourt, Inc. All rights reserved.

5. Insurance  Health insurance - medial bills Copyright © 2000 by Harcourt, Inc. All rights reserved.

6. Insurance  Disability insurance - income Copyright © 2000 by Harcourt, Inc. All rights reserved.

7. Insurance  Property insurance - your home or automobile Copyright © 2000 by Harcourt, Inc. All rights reserved.

8. Insurance  Liability insurance - damage to others or their property Copyright © 2000 by Harcourt, Inc. All rights reserved.

9. Cash reserve Copyright © 2000 by Harcourt, Inc. All rights reserved.

10. Cash reserve  To meet emergency needs Six-month living expense reserve  Liquid investments Easily converted to cash without loss of value Copyright © 2000 by Harcourt, Inc. All rights reserved.

11.  Accumulation phase  Consolidation phase  Spending phase  Gifting phase Copyright © 2000 by Harcourt, Inc. All rights reserved.

12. Net Worth Age 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 Figure 2.1

13.  Near-term, high-priority goals  Long-term, high-priority goals  Lower-priority goals Copyright © 2000 by Harcourt, Inc. All rights reserved.

14. 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 Copyright © 2000 by Harcourt, Inc. All rights reserved. Figure 2.2

15. 1. Policy statement  specifies investment goals and acceptable risk levels  should be reviewed periodically  guides all investment decisions Copyright © 2000 by Harcourt, Inc. All rights reserved.

16. 2. Study current financial and economic conditions and forecast future trends  determine strategies to meet goals  requires monitoring and updates Copyright © 2000 by Harcourt, Inc. All rights reserved.

17. 3. Construct the portfolio  allocate available funds to meet goals and minimize investor’s risks Copyright © 2000 by Harcourt, Inc. All rights reserved.

18. 4. Monitor and update  revise policy statement as needed  modify investment strategy accordingly  evaluate portfolio performance Copyright © 2000 by Harcourt, Inc. All rights reserved.

19.  Understand and articulate realistic investor goals  needs, objectives, and constraints  financial markets and risks of investing Copyright © 2000 by Harcourt, Inc. All rights reserved.

20.  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 markets? Copyright © 2000 by Harcourt, Inc. All rights reserved.

21.  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? Copyright © 2000 by Harcourt, Inc. All rights reserved.

22.  Benchmark portfolio  risk and return  Matches risk preferences and investment needs  analysis of risk tolerance  return objective goals Copyright © 2000 by Harcourt, Inc. All rights reserved.

23.  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 Copyright © 2000 by Harcourt, Inc. All rights reserved.

24.  Total return  capital gains and income reinvestment  moderate risk exposure Copyright © 2000 by Harcourt, Inc. All rights reserved.

25.  Liquidity needs  near-term goals  Time horizon  longer time horizon favors risk acceptability  short time horizon favors less risky investments because losses are harder to overcome in a short time frame Copyright © 2000 by Harcourt, Inc. All rights reserved.

26.  Tax concerns  interest and dividends taxed at investor’s marginal tax rate  capital gains may be unrealized  basis and gain or loss realized  revisions to capital gains tax rates  tradeoff with diversification needs for employer’s stock holdings Copyright © 2000 by Harcourt, Inc. All rights reserved.

27.  Tax concerns (continued)  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 Copyright © 2000 by Harcourt, Inc. All rights reserved.

28.  Limitations or penalties on withdrawals  Fiduciary responsibilities - “prudent man” rule  Investment laws prohibit insider trading Copyright © 2000 by Harcourt, Inc. All rights reserved.

29.  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 Copyright © 2000 by Harcourt, Inc. All rights reserved.

30.  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 importance of diversification Copyright © 2000 by Harcourt, Inc. All rights reserved.

31.  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 Copyright © 2000 by Harcourt, Inc. All rights reserved.

32.  Most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments Copyright © 2000 by Harcourt, Inc. All rights reserved.

33.  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 Copyright © 2000 by Harcourt, Inc. All rights reserved.

34.  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 Copyright © 2000 by Harcourt, Inc. All rights reserved.

35.  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 Copyright © 2000 by Harcourt, Inc. All rights reserved.

36.  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 Copyright © 2000 by Harcourt, Inc. All rights reserved.

37.  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 Copyright © 2000 by Harcourt, Inc. All rights reserved.

38.  Asset allocation determines long-run returns and risk  Success depends on construction of the policy statement Copyright © 2000 by Harcourt, Inc. All rights reserved.

39.  Legal constraints  Investment choices by fund managers Copyright © 2000 by Harcourt, Inc. All rights reserved.

40.  Defined benefit pension plans  actuarial status  liquidity constraint  governed by ERISA Copyright © 2000 by Harcourt, Inc. All rights reserved.

41.  Defined contribution pension plans  liquidity and time horizon  governed by ERISA Copyright © 2000 by Harcourt, Inc. All rights reserved.

42.  Charitable or educational institutions  need for current income  need for increasing future income Copyright © 2000 by Harcourt, Inc. All rights reserved.

43.  Life Insurance Companies  earn rate in excess of actuarial rate  growing surplus  limited by fiduciary principles  liquidity needs  tax rule changes Copyright © 2000 by Harcourt, Inc. All rights reserved.

44.  Nonlife Insurance Companies  cash flows less predictable  fiduciary responsibility to claimants  liquidity concerns  regulation more permissive Copyright © 2000 by Harcourt, Inc. All rights reserved.