Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Sixth Edition
by

Frank K. Reilly & Keith C. Brown

Chapter 2
Saif Ullah
Economist_of_Pakistan@Yahoogroups.com
Saifullah271@yahoo.com
+923216633271

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?

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 persons lifetime and
circumstances?
Why do asset allocation strategies differ
across national boundaries?

Individual Investor
Financial Plan Preliminaries
Insurance
Life insurance

Individual Investor
Financial Plan Preliminaries
Insurance
Life insurance
Term life insurance - death benefit
only, increasing premium at renewal
Cash value life insurance - death
benefit plus savings plan

Individual Investor
Financial Plan Preliminaries
Insurance
Health insurance - medial bills

Individual Investor
Financial Plan Preliminaries
Insurance
Disability insurance - income

Individual Investor
Financial Plan Preliminaries
Insurance
Property insurance - your home or
automobile

Individual Investor
Financial Plan Preliminaries
Insurance
Liability insurance - damage to
others or their property

Individual Investor
Financial Plan Preliminaries
Cash reserve

Individual Investor
Financial Plan Preliminaries
Cash reserve
To meet emergency needs
Six-month living expense reserve

Liquid investments
Easily converted to cash without loss
of value

Individual Investor
Life Cycle

Accumulation phase
Consolidation phase
Spending phase
Gifting phase

Individual Investor Life Cycle

Net Worth

Figure 2.1

Accumulation
Phase

Consolidation Phase Spending Phase

Gifting Phase
Long-term:
Long-term:
Retirement
Long-term:
Retirement
Estate Planning
Short-term:
Childrens college
Short-term:
Vacations
Short-term:
Lifestyle Needs
House
Gifts
Childrens College
Car

25

35

45

55

65

Age

75

Life Cycle Investment Goals

Near-term, high-priority goals
Long-term, high-priority goals
Lower-priority goals

Figure 2.2

The Portfolio Management Process

1. Policy statement - Focus: Investors 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 intermediateterm expected conditions to use in constructing a specific
portfolio
3. Implement the plan by constructing the portfolio - Focus:
Meet the investors needs at the minimum risk levels
4. Feedback loop: Monitor and update investor needs,
environmental conditions, portfolio performance

The Portfolio Management Process

1. Policy statement
specifies investment goals and
acceptable risk levels
should be reviewed periodically
guides all investment decisions

The Portfolio Management Process

2. Study current financial and
economic conditions and forecast
future trends
determine strategies to meet goals
requires monitoring and updates

The Portfolio Management Process

3. Construct the portfolio
allocate available funds to meet
goals and minimize investors risks

The Portfolio Management Process

4. Monitor and update
revise policy statement as needed
modify investment strategy
accordingly
evaluate portfolio performance

The Need For A Policy Statement

Understand and articulate realistic investor
goals
needs, objectives, and constraints
financial markets and risks of investing

Constructing A Policy Statement

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?

Constructing A 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?

Standards For Evaluating

Portfolio Performance
Benchmark portfolio
risk and return

Matches risk preferences and

investment needs
analysis of risk tolerance
return objective goals

Realistic Investor Goals

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

Realistic Investor Goals

Total return
capital gains and income reinvestment
moderate risk exposure

Investment Constraints
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

Investment Constraints
Tax concerns
interest and dividends taxed at investors
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
employers stock holdings

Investment Constraints
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

Equivalent Taxable Yield

Municipal Yield
ETY
1 Marginal Tax Rate

Effect of Tax Deferral on

Investor Wealth over Time
Figure 2.5

Investment
Value

$10,063
8% Tax
Deferred

$5,365
5.76%
After Tax
Return

$1,000
0

10

20

Time
30 years

Methods of Tax Deferral

Regular IRA - tax deductible
withdrawals taxable

Roth IRA - not tax deductible

tax-free withdrawals possible

Cash value life insurance

Annuities
Employers 401(k) and 403(b) plans

Legal and Regulatory Factors

Limitations or penalties on withdrawals
Fiduciary responsibilities prudent man rule
Investment laws prohibit insider trading

Unique Needs and Preferences

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

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 importance of diversification

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
The allowable allocation ranges based on policy
weights
What specific securities to purchase for the
portfolio

The Importance
of Asset Allocation
Most (85% to 95%) of the overall
investment return is due to the first two
decisions, not the selection of individual
investments

The Effect of Taxes and Inflation on

Investment Returns, 1926 - 1998

Figure 2.6

12
10
8
6
4

Before
Taxes

Common Stocks

After After
Taxes Taxes
and
Inflation

Long-Term
Government
Bonds
Treasury Bills

2
0
-2

Municipal Bonds

Returns and Risk of Different

Asset Classes
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

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 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

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 investors
goals and time horizon

Asset Allocation and

Cultural Differences
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

Summary
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

Summary
Asset allocation determines long-run returns
and risk
Success depends on construction of the policy
statement

The Internet
Investments Online

www.ssa.gov
www.amercoll.edu
www.ibbotson.com
www.idfp.org
www.mfea.com
www.napfa.org
www.mfea.com/planidx.html
www.asec.com
www.cccsedu.org/home.html
www.aimr.org
www.iafp.org

Appendix Chapter 2
Objectives and Constraints of
Institutional Investors

Mutual Funds
Legal constraints
Investment choices by fund
managers

Pension Funds
Defined benefit pension plans
actuarial status
liquidity constraint
governed by ERISA

Pension Funds
Defined contribution pension
plans
liquidity and time horizon
governed by ERISA

Endowment Funds
Charitable or educational
institutions
need for current income
need for increasing future
income

Insurance Companies
Life Insurance Companies
earn rate in excess of actuarial rate
growing surplus
limited by fiduciary principles
liquidity needs
tax rule changes

Insurance Companies
Nonlife Insurance Companies
cash flows less predictable
fiduciary responsibility to claimants
liquidity concerns
regulation more permissive

Banks
Must attract funds in a competitive
interest rate environment
tries to maintain a positive difference
between its cost of funds and its return
on assets
liquidity needs
regulatory constraints

End of Chapter 2
The Asset Allocation Decision

Future topics
Chapter 3
Investment choices
Including global assets in asset
allocation decisions