Asset Allocation (2)

8/8/2019 Asset Allocation (2)

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Asset AllocationAsset Allocation What is assetallocation?What is assetallocation?

Whatare fourbasicrisk managementWhatare fourbasicrisk management

strategies?strategies?

Howandwhydo investmentgoalsHowandwhydo investmentgoalschange overa persons lifetime andchange overa persons lifetime and

circumstances?circumstances? Whatare the foursteps inthe portfolioWhatare the foursteps inthe portfolio

management process?management process?


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Asset AllocationAsset Allocation Why is a policy statement importanttotheWhy is a policy statement importanttothe

planning process?planning process?

Whatobjectives andconstraints should beWhatobjectives andconstraints should bedetailed inthe policy statement?detailed inthe policy statement?

Why is investment educationnecessary?Why is investment educationnecessary?

What is the role ofassetallocation inWhat is the role ofassetallocation in

investment planning?investment planning? Whydoassetallocation strategies differWhydoassetallocation strategies differacross national boundaries?across national boundaries?


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What is asset allocation?

What is asset allocation?

The process ofdecidingThe process ofdeciding

howtodistribute wealthhowtodistribute wealth

amongassetclasses,amongassetclasses,sectors, andcountriessectors, andcountries

for investmentfor investment

purposes.purposes.

Notan isolatedchoice,Notan isolatedchoice,

butratheracomponentbutratheracomponentofthe portfolioofthe portfolio

management process.management process.


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Managing Risk

Managing Risk

Since risk drivesSince risk drives

expectedreturn,expectedreturn,

investing involvesinvesting involvesmanagingrisk rathermanagingrisk rather

than managingthan managing

return.return.


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RiskM

anagement StrategiesRiskM

anagement Strategies Risk AvoidanceRisk Avoidance

Canavoidanyrealchances oflossCanavoidanyrealchances ofloss

Generallya poorstrategy except fora partGenerallya poorstrategy except fora part

ofanoverall portfolioofanoverall portfolio

Risk AnticipationRisk Anticipation

Position partofyourportfolioto protectPosition partofyourportfolioto protectagainstanticipatedrisk factorsagainstanticipatedrisk factors

Forexample, maintainacashreserveForexample, maintainacashreserve


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RiskM

anagement StrategiesRiskM

anagement Strategies Risk TransferRisk Transfer

Insurance andother investmentvehicles canInsurance andother investmentvehicles can

allow forthe transferofrisk, oftenata price, toallow forthe transferofrisk, oftenata price, toanother investorwho is willingto bearthe riskanother investorwho is willingto bearthe risk

Risk ReductionRisk Reduction

Effective diversificationandassetallocationEffective diversificationandassetallocation

strategies canreduce risk, sometimes withoutstrategies canreduce risk, sometimes withoutsacrificing expectedreturn.sacrificing expectedreturn.


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Individual

Investor Life Cycle

Individual

Investor Life Cycle

The individual investors life cycle canThe individual investors life cycle can

often be describedusing fourseparateoften be describedusing fourseparate

phases orstages:phases orstages:

Accumulation PhaseAccumulation Phase

Consolidation PhaseConsolidation Phase

Spending PhaseSpending Phase

Gifting PhaseGifting Phase


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Accumulation Ph

aseAccumulation Ph

ase Earlyto middle years ofcareersEarlyto middle years ofcareers

Attemptingto satisfy intermediate andlongAttemptingto satisfy intermediate andlong--

term goalsterm goals

Networth is usually small, debt may beNetworth is usually small, debt may be

heavyheavy

LongLong--term investmenthorizon means usuallyterm investmenthorizon means usuallywillingtotake moderatelyhighrisks inorderwillingtotake moderatelyhighrisks inorder

to make aboveto make above--average returnsaverage returns


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Consolidation Ph

aseConsolidation Ph

ase PastcareermidpointPastcareermidpoint

Have paidoff muchoftheirHave paidoff muchoftheir

accumulateddebtaccumulateddebt

Earnings now exceedliving expenses,Earnings now exceedliving expenses,sothe balance can be investedsothe balance can be invested

Time horizon is stilllongTime horizon is stilllong--term, soterm, somoderatelyhighrisk investments aremoderatelyhighrisk investments arestillattractivestillattractive


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Spending Ph

aseSpending Ph

ase Usually begins atretirementUsually begins atretirement

Saving before, prudent spendingnowSaving before, prudent spendingnow

Living expenses covered by SocialLiving expenses covered by SocialSecurityandretirement plansSecurityandretirement plans

Changing emphasis towardChanging emphasis toward

preservationofcapital, but stillwantpreservationofcapital, but stillwantinvestmentvalues to keep pace withinvestmentvalues to keep pace withinflationinflation


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Gifting P

hase

Gifting P

hase

Can be concurrentwith spending phaseCan be concurrentwith spending phase

Ifresources allow, individuals cannowIfresources allow, individuals cannow

use excess assets to provide gifts touse excess assets to provide gifts to

other individuals ororganizationsother individuals ororganizations

Estate planning becomes important,Estate planning becomes important,

especiallytax considerationsespeciallytax considerations


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The Portfolio ManagementThe Portfolio Management

ProcessProcessA fourstep process:A fourstep process:

1.1. Constructa policy statementConstructa policy statement

2.2. Studycurrent financialconditions andStudycurrent financialconditions and

forecast future trendsforecast future trends

3.3. Constructa portfolioConstructa portfolio

4.4. Monitorneeds andconditionsMonitorneeds andconditions


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ProcessProcess1. Policy statement1. Policy statement

Specifies investmentgoals andacceptableSpecifies investmentgoals andacceptable

risk levelsrisk levels

The road map thatguides all investmentThe road map thatguides all investment

decisionsdecisions


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ProcessProcess2. Studycurrent financialand economic2. Studycurrent financialand economic

conditions and forecast future trendsconditions and forecast future trends

Determine strategies that should meetDetermine strategies that should meet

goals withinthe expected environmentgoals withinthe expected environment

Requires monitoringandupdates sinceRequires monitoringandupdates since

financial markets are everfinancial markets are ever--changingchanging


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ProcessProcess3. Constructthe portfolio3. Constructthe portfolio

Giventhe policy statementandtheGiventhe policy statementandthe

expectedconditions, goabout investingexpectedconditions, goabout investing

Allocate available funds to meetgoalsAllocate available funds to meetgoals

while managingriskwhile managingrisk


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ProcessProcess4. Monitorandupdate4. Monitorandupdate

Revise policy statementas neededRevise policy statementas needed

Monitorchanging financialand economicMonitorchanging financialand economic

conditionsconditions

Evaluate portfolio performanceEvaluate portfolio performance

Modify portfolio investments accordinglyModify portfolio investments accordingly


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The Policy Statement


Understandandarticulate realisticgoalsUnderstandandarticulate realisticgoals

KnowyourselfKnowyourself

Knowthe risks and potentialrewards fromKnowthe risks and potentialrewards frominvestmentsinvestments

Learnabout standards forevaluating portfolioLearnabout standards forevaluating portfolio

performanceperformance

Knowhowto judge average performanceKnowhowto judge average performance

Adjust forriskAdjust forrisk


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DonttrytonavigateDonttrytonavigate

withouta map!withouta map!

Important Inputs:Important Inputs: InvestmentInvestment

ObjectivesObjectives

InvestmentInvestment

ConstraintsConstraints


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Investment ObjectivesInvestment Objectives

Needto specifyreturnNeedto specifyreturn

andrisk objectivesandrisk objectives

NeedtoconsidertheNeedtoconsidertherisk tolerance oftherisk tolerance ofthe

investorinvestor

Returngoals needtoReturngoals needto

be consistentwithbe consistentwithrisk tolerancerisk tolerance

These willchangeThese willchange

overtimeovertime


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Investment ObjectivesInvestment Objectives

Possible broadgoals:Possible broadgoals:

Capital preservationCapital preservation

Maintain purchasing powerMaintain purchasing power

Minimize the risk oflossMinimize the risk ofloss

CapitalappreciationCapitalappreciation

Achieve portfoliogrowththroughcapitalAchieve portfoliogrowththroughcapitalgainsgains

AcceptgreaterriskAcceptgreaterrisk


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I

nvestment ObjectivesI

nvestment Objectives Current incomeCurrent income

Look togenerate income ratherthancapitalgainsLook togenerate income ratherthancapitalgains

May be preferred in spending phaseMay be preferred in spending phase RelativelylowriskRelativelylowrisk

TotalreturnTotalreturn

Combining income returns andreinvestmentwithCombining income returns andreinvestmentwith

capitalgainscapitalgains

Moderate riskModerate risk


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I

nvestment ConstraintsI

nvestment ConstraintsThese factors maylimitoratleast impacttheThese factors maylimitoratleast impactthe

investmentchoices:investmentchoices:

LiquidityneedsLiquidityneeds How soonwillthe money be needed?How soonwillthe money be needed?

Time horizonTime horizon Howable is the investortoride out several badHowable is the investortoride out several bad

years?years? LegalandRegulatory FactorsLegalandRegulatory Factors

Legalrestrictions oftenconstraindecisionsLegalrestrictions oftenconstraindecisions

RetirementregulationsRetirementregulations


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I

nvestment ConstraintsI

nvestment Constraints Tax ConcernsTax Concerns

Realizedcapitalgains vs. Ordinary income?Realizedcapitalgains vs. Ordinary income?

Taxable vs. TaxTaxable vs. Tax--exempt bonds?exempt bonds? Regular IRA vs. Roth IRA?Regular IRA vs. Roth IRA?

401(k) and403(b) plans401(k) and403(b) plans

Unique needs and preferencesUnique needs and preferences

Perhaps the investorwishes toavoidtypes ofPerhaps the investorwishes toavoidtypes of

investments forethicalreasonsinvestments forethicalreasons


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I

nvestment EducationI

nvestment Education The type of informationnecessarytoThe type of informationnecessarytoconstructagood policy statement is neitherconstructagood policy statement is neither

common sense orcommon knowledge.common sense orcommon knowledge. Many investors failtodiversify.Many investors failtodiversify.

Many failto plancompletely.Many failto plancompletely.

Data indicates that many Americans haveData indicates that many Americans have

greatlyundergreatlyunder--invested forthe future.invested forthe future. The bottom line: Ifyoudonot plan fortheThe bottom line: Ifyoudonot plan forthe

future, youwilllikelynot be prepared for it.future, youwilllikelynot be prepared for it.


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Asset Allocation DecisionsAsset Allocation DecisionsFourdecisions inan investment strategy:Fourdecisions inan investment strategy:

Whatassetclasses should be considered?Whatassetclasses should be considered?

What should be the normalweight foreachWhat should be the normalweight foreach

assetclass?assetclass?

Whatare the allowable ranges fortheWhatare the allowable ranges forthe

weights?weights? What specific securities should beWhat specific securities should be

purchased?purchased?


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The Importance of AssetThe Importance of Asset

AllocationAllocation The assetallocationdecision (whichclassesThe assetallocationdecision (whichclasses

andatwhatweights) is very important. Usingandatwhatweights) is very important. Using

funddata:funddata: About 90%ofreturnvariabilityovertime can beAbout 90%ofreturnvariabilityovertime can be

explained byassetallocation.explained byassetallocation.

About40%ofthe differences betweenreturns canAbout40%ofthe differences betweenreturns can

be explained bydifferences inassetallocation.be explained bydifferences inassetallocation. Assetallocation is thus the majorfactorthatAssetallocation is thus the majorfactorthat

drives portfoliorisk andreturn.drives portfoliorisk andreturn.


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Risk/Return History andRisk/Return History and

Asset AllocationAsset AllocationLookingatreturndataonvarious assetclassesLookingatreturndataonvarious assetclasses

indicate some important factors for investors:indicate some important factors for investors:

Overlongtime horizons, stocks have alwaysOverlongtime horizons, stocks have alwaysoutperformedlowoutperformedlow--risk investments.risk investments.

Sothe additionalrisk of stock investing (higherSothe additionalrisk of stock investing (higher

return standarddeviations) overshortertimereturn standarddeviations) overshortertime

horizons seems toall butdisappearovertime.horizons seems toall butdisappearovertime. Needtoconsiderreal investmentreturns overNeedtoconsiderreal investmentreturns over

taxes andcoststaxes andcosts


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Asset Allocation and CulturalAsset Allocation and Cultural

DifferencesDifferences Differences in social, political, andtaxDifferences in social, political, andtax

environments influence assetallocation.environments influence assetallocation.

For instance, 58%of pension fundassets areFor instance, 58%of pension fundassets areinvested in equities inthe U.S.invested in equities inthe U.S.

78% in equities in United Kingdom, where high78% in equities in United Kingdom, where high

average inflation impacts this choiceaverage inflation impacts this choice

8% in equities in Germany, where generous8% in equities in Germany, where generousgovernment pensions andgreaterrisk aversiongovernment pensions andgreaterrisk aversion

seem to playa strongroleseem to playa strongrole

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Asset Allocation (2)