Course

: Z1462 Investment Analysis

and Portfolio Management
Effective Period : February 2016

The Asset Allocation

Decision
Session 3

Acknowledgement

These slides have been adapted from:

Frank K. Reilly & Keith C. Brown. (2012). Analysis
of Investments and Management of Portfolios. 10.
Cengage Learning. ISBN: 9780538482486

Chapter 2: The Asset Allocation

Decision

Analysis of Investments &

Management of Portfolios
10TH EDITION

Reilly

& Brown

2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

What is Asset Allocation?

Asset Allocation: It is the process of deciding
how to distribute an investors wealth among
different countries and asset classes for
investment purposes.
Asset Class: It refers to the group of securities
that have similar characteristics, attributes, and
risk/return relationships.
Investor: Depending on the type of investors,
investment objectives and constraints vary
Individual investors
Institutional investors
2-4
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Individual Investor Life Cycle

Financial Plan Preliminaries
Life Insurance: Providing death benefits and,
possibly, additional cash values
Term life and whole life insurance
Universal and variable life insurance

Non-life Insurance
Health insurance & Disability insurance
Automobile insurance & Home/rental insurance

Cash Reserve
To meet emergency needs
Equal to six months living expenses
2-5
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Individual Investor Life Cycle

Life Cycle Phases. The four life-cycle phases
are shown in Exhibit 2.1 (the third and fourth
phases-spending and gifting-are shown as
concurrent) and described here.
Accumulation phase: Early to middle years of
working career (Exhibit 2.2)
Consolidation phase: Past midpoint of careers.
Earnings greater than expenses
Spending/Gifting phase: Begins after retirement

2-6
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 2.1

2-7
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Individual Investor Life Cycle

Life Cycle Investment Goals
Near-term, high-priority goals
Long-term, high-priority goals
Lower-priority goals

Exhibit 2.2 shows growth from an initial $ 10,000

investment over 20,30, and 40 years at assumed
annual returns of 7 and 8%. The middle-aged
person who invest $ 10,000 when he or she
can afford it will only reap the benefits of
compounding for 20 years or so before
retirement.
2-8
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 2.2

2-9
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Portfolio Management Process

Policy Statement
Specifies investment goals and acceptable risk levels
Should be reviewed periodically
Guides all investment decisions

Study Current Financial and Economic conditions

and forecast future trends
Determine strategies to meet goals
Requires monitoring and updating

2-10
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Portfolio Management Process

Construct the Portfolio
Allocate available funds to minimize investors risks and
meet investment goals

Monitor and Update

Evaluate portfolio performance

Monitor investors needs and market conditions
Revise policy statement as needed
Modify investment strategy accordingly

2-11
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Portfolio Management Process

Exhibit 2.3
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 intermediate-term 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
2-12
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Need For A Policy Statement

Understand investors needs and articulate
realistic investment objectives and constraints
What are the real risks of an adverse financial
outcome, and what emotional reactions will I have?
How knowledgeable am I about investments and the
financial markets?
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 affect me?
How would any unanticipated portfolio value change
might affect my investment policy?
2-13
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Need For A Policy Statement

Sets standards for evaluating portfolio
performance
The statement provides a comparison standard in
judging the performance of the portfolio manager.
A benchmark portfolio or comparison standard is
used to reflect the risk an return objectives
specified in the policy statement.
It should act as a starting point for periodic
portfolio review and client communication with the
manager.
2-14
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Need For A Policy Statement

Other Benefits
It helps reduces the possibility of inappropriate or
unethical behavior on the part of the portfolio
manager.
A clearly written policy statement will help create
seamless transition from one money manager to
another without costly delays.
It also provides the framework to help resolve any
potential disagreements between the client and
the manager.

2-15
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Constructing the Policy Statement

Constructing the policy statement begins with
a profile analysis of the investors current and
future financial situations and a discussion of
investment objectives and constraints.
Objectives
Risk
Return

Constraints
Liquidity, time horizon, tax factors, legal and
regulatory constraints, and unique needs and
preferences
2-16
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Constructing the Policy Statement

In general, there are for decision involved in
constructing an investment strategy :
What asset classes should be considered for
investment ?
What policy weights should be assigned to each
eligible asset class ?
What are the allowable allocation ranges based on
policy weights ?
What specific securities or funds should be
purchased for the portfolio ?
2-17
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Investment Objectives
Risk Objectives
Risk objective should be based on investors
ability to take risk and willingness to take risk.
Risk tolerance depends on an investors current
net worth and income expectations and age.
More net worth allows more risk taking
Younger people can take more risk

A careful analysis of the clients risk tolerance

should precede any discussion of return
objectives.
2-18
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Investment Objectives
Return Objectives
The return objective may be stated in terms of an
absolute or a relative percentage return.
Capital Preservation: Minimize risk of real losses
Capital Appreciation: Growth of the portfolio in
real terms to meet future need
Current Income: Focus is in generating income
rather than capital gains
Total Return: Increase portfolio value by capital
gains and by reinvesting current income with
moderate risk exposure
2-19
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Investment Constraints
Liquidity Needs
Vary between investors depending upon age,
employment, tax status, etc.
Planned vacation expenses and house down
payment are some of the liquidity needs.

Time Horizons
Influences liquidity needs and risk tolerance.
Longer investment horizons generally requires
less liquidity and more risk tolerance.
Two general time horizons are pre-retirement and
post-retirement periods.
2-20
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Investment Constraints
Tax Concerns
Capital gains or losses: Taxed differently from
income
Unrealized capital gains: Reflect price
appreciation of currently held assets that have not
yet been sold
Realized capital gains occur when the asset has
been sold at a profit
Trade-off between taxes and diversification: Tax
consequences of selling company stock for
diversification purposes
2-21
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Investment Constraints
Tax concerns (continued)
Interest on municipal bonds exempt from federal
income tax and from state of issue

Equivalent Taxable Yield

Municipal Yield
(1 - Marginal Tax Rate)

Interest on federal securities exempt from state

income tax
Contributions to an IRA may qualify as deductible
from taxable income
Tax deferral considerations
2-22
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Methods of Tax Deferral

Regular IRA
Tax deductible
Tax on returns deferred until withdrawal

Roth IRA
Not tax deductible
Tax-free withdrawals possible

Cash Value Life Insurance

Funds accumulate tax-free until they are withdrawn

Tax Sheltered Annuities

Employers 401(k) and 403(b) Plans
Tax-deferred investments
2-23
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Legal and Regulatory Factors

Limitations or penalties on withdrawals
Fiduciary responsibilities
The Prudent Investor Rule normally apply

Investment laws prohibit insider trading

Institutional investors deserve special
attentions since legal and regulatory factors
may affect them quite differently (e.g. banks
vs. endowment funds).

2-24
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unique Needs and Preferences

Personal preferences such as socially
conscious investments could influence
investment choice.
Time constraints or lack of expertise for
managing the portfolio may require
professional management.
Large investment in employers stock may
require consideration of diversification needs.
Institutional investors needs.

2-25
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Importance of Asset Allocation

An investment strategy is based on four
decisions
What asset classes to consider for investment
What policy weights to assign to each eligible class
What allocation ranges are allowed based on policy
weights
What specific securities to purchase for the portfolio

According to research studies, most (90%) of

the overall investment return is due to the first
two decisions, not the selection of individual
investments (see Exhibit 2.7)
2-26
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 2.7

2-27
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 2.8

2-28
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Importance of Asset Allocation

Returns and Risks of Different Asset Classes
Historically, small company stocks have generated
the highest returns, so have the volatility
Inflation and taxes have a major impact on returns
Returns on Treasury Bills have barely kept pace
with inflation
Measuring risk by the probability of not meeting
your investment return objective indicates risk of
equities is small and that of T-bills is large because
of their differences in expected returns
Focusing only on return variability as a measure of
risk ignores reinvestment risk
2-29
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 2.9

2-30
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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

2-31
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Asset Allocation Summary

Asset Allocation and Cultural Differences
Social, political, and tax environments influence the
asset allocation decision
Equity allocations of U.S. pension funds average
58%
In the United Kingdom, equities make up 78% of
assets
In Germany, equity allocation averages 8%
In Japan, equities are 37% of assets
See Exhibits 2.11 and 2.12

2-32

2-32

2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 2.11

2-33
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 2.12

2-34
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Internet Investments Online

http://www.ssa.gov
http://ww.ibbotson.com
http://www.mfea.com/
http://InvestmentStrategies/Calculators/default.asp
http://www.asec.org
http://www.financialengines.com
http://www.cfainstitute.org
http://www.troweprice.com
http://www.theamericancollege.edu
http://www.cfp.net
http://www.napfa.org
http://www.fpanet.org
http://www.decisioneering.com
2-35

2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Objectives and Constraints

of Institutional Investors
Mutual Funds
Pool investors funds and invests them in financial
assets as per its investment objective

Endowment Funds
They represent contributions made to charitable or
educational institutions

2-36
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Objectives and Constraints

of Institutional Investors
Pension Funds
Receive contributions from the firm, its employees,
or both and invests those funds
Defined Benefit promise to pay retirees a
specific income stream after retirement
Defined Contribution do not promise a set of
benefits. Employees retirement income is not an
obligation of the firm

2-37
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Objectives and Constraints

of Institutional Investors
Insurance Companies
Life Insurance Companies
earn rate in excess of actuarial rate
growing surplus if the spread is positive
fiduciary principles limit the risk tolerance
liquidity needs have increased
tax rule changes

2-38
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Objectives and Constraints

of Institutional Investors
Insurance Companies
Nonlife Insurance Companies
cash flows less predictable
fiduciary responsibility to claimants
Risk exposure low to moderate
liquidity concerns due to uncertain claim patterns
regulation more permissive

2-39
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Objectives and Constraints

of Institutional Investors
Banks
Must attract funds in a competitive interest rate
environment
Try to maintain a positive difference between their
cost of funds and their return on assets
Need substantial liquidity to meet withdrawals and
loan demands
Face regulatory constraints

2-40
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

THANK YOU