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Capital appreciation
Achieve portfolio growth through capital
gains
Accept greater risk
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
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
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
Investment Education
The type of information necessary to
construct a good policy statement is neither
“common sense” or “common knowledge.”
Many investors fail to diversify.
Many fail to plan completely.
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.
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?
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.
Risk/Return History and
Asset Allocation
Looking at return data on various asset classes
indicate some important factors for investors:
Even apparent low-risk investments like T-
bills can have considerable reinvestment risk
Over long time horizons, stocks have always
outperformed low-risk investments.
So the additional risk over shorter time horizons
seems to all but disappear over time.
The only way to maintain purchasing power,
net of taxes and inflation, is by investing in
common stock (see Exhibit 5.11).
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.
79% 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