Asset Allocation Decision

8/18/2019 Asset Allocation Decision

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The Asset Allocation

DecisionSession 3

Course : Z1462 Investment Analysis

and Portfolio Management

Eective Period : e!ruary 2"16


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These slides have been adapted from:

Frank K. Reilly & Keith C. Brown. (2!2". Analysis

of Investments and Management of Portfolios. !.

Cen#a#e $earnin#. %B': )*+,*-*2-*

These slides have been adapted from:

Frank K. Reilly & Keith C. Brown. (2!2". Analysis

of Investments and Management of Portfolios. !.

Cen#a#e $earnin#. %B': )*+,*-*2-*

/0knowled#ement


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

Chapter 2: The /sset /llo0ation

1e0ision

Chapter 2: The /sset /llo0ation

1e0ision

Analysis of Investments& Management of Portfolios

10! "#$$%&

Reilly& Brown


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hat is /sset /llo0ation3hat is /sset /llo0ation3

•

Asset Allocation' $t is the process o( decidinghow to distribute an investor)s wealth a*ongdi((erent countries and asset classes (orinvest*ent purposes.

• Asset Class' $t re(ers to the group o( securitiesthat have si*ilar characteristics, attributes, andris+return relationships.

•

$nvestor' #epending on the type o( investors,invest*ent ob-ectives and constraints vary

– $ndividual investors – $nstitutional investors

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%ndivid4al %nvestor $ife Cy0le%ndivid4al %nvestor $ife Cy0le

•

inancial lan reli*inaries – Li(e $nsurance' roviding death bene(its and,

possibly, additional cash values• er* li(e and whole li(e insurance

•niversal and variable li(e insurance

– &onli(e $nsurance• !ealth insurance 3 #isability insurance

• Auto*obile insurance 3 !o*erental insurance

– Cash Reserve• o *eet e*ergency needs

• "4ual to si5 *onths living e5penses

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•

Li(e Cycle hases. he (our li(ecycle phasesare shown in "5hibit 2.1 7the third and (ourth

phasesspending and gi(tingare shown as

concurrent8 and described here.

– Accu*ulation phase' "arly to *iddle years o(

wor+ing career 7"5hibit 2.28

– Consolidation phase' ast *idpoint o( careers.

"arnings greater than e5penses – 9pending:i(ting phase' ;egins a(ter retire*ent

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56hibit 2.!56hibit 2.!

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• Li(e Cycle $nvest*ent :oals

– &earter*, highpriority goals

– Longter*, highpriority goals

– Lowerpriority goals

> "5hibit 2.2 shows growth (ro* an initial ? 10,000invest*ent over 20,@0, and /0 years at assu*ed

annual returns o( = and B. he *iddleaged

person who invest ? 10,000 when he or shecan a((ord itD will only reap the bene(its o(

co*pounding (or 20 years or so be(ore

retire*ent.2



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56hibit 2.256hibit 2.2

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The 7ortfolio 8ana#ement 7ro0essThe 7ortfolio 8ana#ement 7ro0ess

•

olicy 9tate*ent – 9peci(ies invest*ent goals and acceptable ris+ levels

– 9hould be reviewed periodically

– :uides all invest*ent decisions

• 9tudy Current inancial and "cono*ic conditions

and (orecast (uture trends – #eter*ine strategies to *eet goals

– Re4uires *onitoring and updating



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•

Construct the ort(olio – Allocate available (unds to *ini*iFe investor)s ris+s and

*eet invest*ent goals

• Monitor and pdate – "valuate port(olio per(or*ance

– Monitor investor)s needs and *ar+et conditions

– Revise policy state*ent as needed

–

Modi(y invest*ent strategy accordingly



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1. olicy 9tate*ent

ocus' $nvestor)s shortter* and longter* needs,(a*iliarity with capital *ar+et history, and e5pectations

2. "5a*ine current and pro-ect (inancial, econo*ic,political, and social conditionsocus' 9hortter* and inter*ediateter* e5pectedconditions to use in constructing a speci(ic port(olio

@. $*ple*ent the plan by constructing the port(olioocus' Meet the investor)s needs at the *ini*u* ris+levels

/. eedbac+ loop' Monitor and update investor needs,environ*ental conditions, port(olio per(or*ance

212

56hibit 2.,



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The 'eed For / 7oli0y tatementThe 'eed For / 7oli0y tatement

• nderstand investor)s needs and articulate

realistic invest*ent ob-ectives and constraints – Ghat are the real ris+s o( an adverse (inancial

outco*e, and what e*otional reactions will $ haveH

–

!ow +nowledgeable a* $ about invest*ents and the(inancial *ar+etsH

– Ghat other capital or inco*e sources do $ haveH!ow i*portant is this particular port(olio to *y overall(inancial positionH

– Ghat, i( any, legal restrictions a((ect *eH

– !ow would any unanticipated port(olio value change*ight a((ect *y invest*ent policyH

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•

9ets standards (or evaluating port(olioper(or*ance

– he state*ent provides a co*parison standard in

-udging the per(or*ance o( the port(olio *anager.

– A bench*ar+ port(olio or co*parison standard is

used to re(lect the ris+ an return ob-ectives

speci(ied in the policy state*ent.

– $t should act as a starting point (or periodic

port(olio review and client co**unication with the

*anager.

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•

%ther ;ene(its – $t helps reduces the possibility o( inappropriate or

unethical behavior on the part o( the port(olio*anager.

–

A clearly written policy state*ent will help createsea*less transition (ro* one *oney *anager toanother without costly delays.

– $t also provides the (ra*ewor+ to help resolve any

potential disagree*ents between the client andthe *anager.

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Constr40tin# the 7oli0y tatementConstr40tin# the 7oli0y tatement

•

Constructing the policy state*ent begins witha pro(ile analysis o( the investor)s current and(uture (inancial situations and a discussion o(invest*ent ob-ectives and constraints.

• %b-ectives

– Ris+ – Return

•

Constraints – Li4uidity, ti*e horiFon, ta5 (actors, legal and

regulatory constraints, and uni4ue needs and

pre(erences

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Constr40tin# the 7oli0y tatementConstr40tin# the 7oli0y tatement

•

$n general, there are (or decision involved inconstructing an invest*ent strategy '

– Ghat asset classes should be considered (or

invest*ent H

– Ghat policy weights should be assigned to each

eligible asset class H

– Ghat are the allowable allocation ranges based on

policy weights H

– Ghat speci(ic securities or (unds should be

purchased (or the port(olio H



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%nvestment 9be0tives%nvestment 9be0tives

•

Ris+ %b-ectives – Ris+ ob-ective should be based on investor)s

ability to ta+e ris+ and willingness to ta+e ris+.

– Ris+ tolerance depends on an investor)s current

net worth and inco*e e5pectations and age.• More net worth allows *ore ris+ ta+ing

• Iounger people can ta+e *ore ris+

– A care(ul analysis o( the client)s ris+ tolerance

should precede any discussion o( return

ob-ectives.



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%nvestment 9be0tives%nvestment 9be0tives

•

Return %b-ectives – he return ob-ective *ay be stated in ter*s o( an

absolute or a relative percentage return.

– Capital reservation' Mini*iFe ris+ o( real losses

– Capital Appreciation' :rowth o( the port(olio inreal ter*s to *eet (uture need

– Current $nco*e' ocus is in generating inco*e

rather than capital gains

– otal Return' $ncrease port(olio value by capital

gains and by reinvesting current inco*e with

*oderate ris+ e5posure

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%nvestment Constraints%nvestment Constraints

•

Li4uidity &eeds – Jary between investors depending upon age,

e*ploy*ent, ta5 status, etc.

– lanned vacation e5penses and house down

pay*ent are so*e o( the li4uidity needs.• i*e !oriFons

– $n(luences li4uidity needs and ris+ tolerance.

– Longer invest*ent horiFons generally re4uires

less li4uidity and *ore ris+ tolerance. – wo general ti*e horiFons are preretire*ent and

postretire*ent periods.



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•

a5 Concerns – Capital gains or losses' a5ed di((erently (ro*

inco*e

– nrealiFed capital gains' Re(lect price

appreciation o( currently held assets that have notyet been sold

– RealiFed capital gains occur when the asset hasbeen sold at a pro(it

–

radeo(( between ta5es and diversi(ication' a5conse4uences o( selling co*pany stoc+ (ordiversi(ication purposes



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•

a5 concerns 7continued8 – $nterest on *unicipal bonds e5e*pt (ro* (ederal

inco*e ta5 and (ro* state o( issue

– $nterest on (ederal securities e5e*pt (ro* stateinco*e ta5

– Contributions to an $RA *ay 4uali(y as deductible(ro* ta5able inco*e

– a5 de(erral considerations

222

Rate)TaxMarginal-(1

YieldMunicipal

YieldTaxableEquivalent



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8ethods of Ta6 1eferral8ethods of Ta6 1eferral

•

Regular $RA – a5 deductible – a5 on returns de(erred until withdrawal

• Roth $RA –

&ot ta5 deductible – a5(ree withdrawals possible

• Cash Jalue Li(e $nsurance – unds accu*ulate ta5(ree until they are withdrawn

•a5 9heltered Annuities

• "*ployer)s /017+8 and /0@7b8 lans – a5de(erred invest*ents

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$e#al and Re#4latory Fa0tors$e#al and Re#4latory Fa0tors

•

Li*itations or penalties on withdrawals• iduciary responsibilities

– he rudent $nvestor RuleD nor*ally apply

• $nvest*ent laws prohibit insider trading

• $nstitutional investors deserve specialattentions since legal and regulatory (actors*ay a((ect the* 4uite di((erently 7e.g. ban+s

vs. endow*ent (unds8.

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;ni


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The %mportan0e of /sset /llo0ationThe %mportan0e of /sset /llo0ation

•

An invest*ent strategy is based on (ourdecisions – Ghat asset classes to consider (or invest*ent

– Ghat policy weights to assign to each eligible class

– Ghat allocation ranges are allowed based on policyweights

– Ghat speci(ic securities to purchase (or the port(olio

• According to research studies, *ost 7E0B8 o(

the overall invest*ent return is due to the (irsttwo decisions, not the selection o( individualinvest*ents 7see "5hibit 2.=8

22


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56hibit 2.)56hibit 2.)



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56hibit 2.*56hibit 2.*

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The %mportan0e of /sset /llo0ationThe %mportan0e of /sset /llo0ation

•Returns and Ris+s o( #i((erent Asset Classes – !istorically, s*all co*pany stoc+s have generated

the highest returns, so have the volatility

– $n(lation and ta5es have a *a-or i*pact on returns

– Returns on reasury ;ills have barely +ept pacewith in(lation

– Measuring ris+ by the probability o( not *eetingyour invest*ent return ob-ective indicates ris+ o(

e4uities is s*all and that o( bills is large becauseo( their di((erences in e5pected returns

– ocusing only on return variability as a *easure o(ris+ ignores reinvest*ent ris+

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/sset /llo0ation 4mmary/sset /llo0ation 4mmary

•olicy state*ent deter*ines types o( assetsto include in port(olio

• Asset allocation deter*ines port(olio return*ore than stoc+ selection

• %ver long ti*e periods, siFable allocation toe4uity will i*prove results

• Ris+ o( a strategy depends on the investor)s

goals and ti*e horiFon

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2@2

/sset /llo0ation 4mmary/sset /llo0ation 4mmary

•

Asset Allocation and Cultural #i((erences – 9ocial, political, and ta5 environ*ents in(luence the

asset allocation decision

– "4uity allocations o( .9. pension (unds average

6B – $n the nited Kingdo*, e4uities *a+e up =B o(

assets

– $n :er*any, e4uity allocation averages B

–

$n apan, e4uities are @=B o( assets – 9ee "5hibits 2.11 and 2.12

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The %nternet %nvestments 9nlineThe %nternet %nvestments 9nline

• http'www.ssa.gov

• http'ww.ibbotson.co*

• http'www.*(ea.co*

• http'$nvest*ent9trategiesCalculatorsde(ault.asp

• http'www.asec.org

• http'www.(inancialengines.co*• http'www.c(ainstitute.org

• http'www.troweprice.co*

• http'www.thea*ericancollege.edu

• http'www.c(p.net

• http'www.nap(a.org

• http'www.(panet.org

• http'www.decisioneering.co*

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.

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


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/ppendi6: 9be0tives and Constraints

of %nstit4tional %nvestors

• Mutual unds – ool investors (unds and invests the* in (inancial

assets as per its invest*ent ob-ective

• "ndow*ent unds – hey represent contributions *ade to charitable or

educational institutions

2@


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• ension unds – Receive contributions (ro* the (ir*, its e*ployees,

or both and invests those (unds

– 1efined Benefit pro*ise to pay retirees a

speci(ic inco*e strea* a(ter retire*ent – 1efined Contrib4tion do not pro*ise a set o(

bene(its. "*ployees) retire*ent inco*e is not anobligation o( the (ir*

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/ppendi6: 9be0tives and Constraintsof %nstit4tional %nvestors

• $nsurance Co*panies – Li(e $nsurance Co*panies

• earn rate in e5cess o( actuarial rate

•

growing surplus i( the spread is positive• (iduciary principles li*it the ris+ tolerance

• li4uidity needs have increased

• ta5 rule changes

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9 C


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• $nsurance Co*panies – &onli(e $nsurance Co*panies

• cash (lows less predictable

• (iduciary responsibility to clai*ants

• Ris+ e5posure low to *oderate

• li4uidity concerns due to uncertain clai* patterns

• regulation *ore per*issive

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/ di 9b ti d C t i t


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• ;an+s – Must attract (unds in a co*petitive interest rate

environ*ent

– ry to *aintain a positive di((erence between their

cost o( (unds and their return on assets – &eed substantial li4uidity to *eet withdrawals and

loan de*ands

– ace regulatory constraints

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Asset Allocation Decision