Transcript Lecture Presentation for Investments, 7e

Chapter 4
INVESTMENT POLICY STATEMENTS AND
ASSET ALLOCATION ISSUES
Chapter 4 Questions
 What is asset allocation?
 What are four basic risk management strategies?
 How and why do investment goals change over a
person’s lifetime and circumstances?
 What are the four steps in the portfolio
management process?
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What is asset allocation?
 The process of deciding how
to distribute wealth among
asset classes, sectors, and
countries for investment
purposes.
 Not an isolated choice, but
rather a component of the
portfolio management process.
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Managing Risk
Since risk drives expected
return, investing involves
managing risk rather than
managing return.
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Risk Management Strategies
 Risk Avoidance
 Can avoid any real chances of loss
 Generally a poor strategy except for a part of an overall
portfolio
 Risk Anticipation
 Position part of your portfolio to protect against
anticipated risk factors
 For example, maintain a cash reserve
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Risk Management Strategies
 Risk Transfer
 Insurance and other investment vehicles can allow for the
transfer of risk, often at a price, to another investor who is
willing to bear the risk
 Risk Reduction
 Effective diversification and asset allocation strategies can
reduce risk, sometimes without sacrificing expected return.
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Individual Investor Life Cycle
The individual investors life cycle can often be
described using four separate phases or stages:
 Accumulation Phase
 Consolidation Phase
 Spending Phase
 Gifting Phase
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Accumulation Phase
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Early to middle years of careers
Attempting to satisfy intermediate and long-term goals
Net worth is usually small, debt may be heavy
Long-term investment horizon means usually willing to take
moderately high risks in order to make above-average
returns
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Consolidation Phase
 Past career midpoint
 Have paid off much of their accumulated debt
 Earnings now exceed living expenses, so the
balance can be invested
 Time horizon is still long-term, so moderately high
risk investments are still attractive
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Spending Phase
 Usually begins at retirement
 Saving before, prudent spending now
 Living expenses covered by Social Security and
retirement plans
 Changing emphasis toward preservation of capital,
but still want investment values to keep pace with
inflation
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Gifting Phase
 Can be concurrent with spending phase
 If resources allow, individuals can now use excess
assets to provide gifts to other individuals or
organizations
 Estate planning becomes important, especially tax
considerations
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The Portfolio Management Process
A four step process:
1. Construct a policy statement
2. Study current financial conditions and forecast
future trends
3. Construct a portfolio
4. Monitor needs and conditions
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The Portfolio Management Process
1. Policy statement
 Specifies investment goals and acceptable risk levels
 The “road map” that guides all investment decisions
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The Portfolio Management Process
2. Study current financial and economic conditions
and forecast future trends
 Determine strategies that should meet goals within the
expected environment
 Requires monitoring and updates since financial
markets are ever-changing
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The Portfolio Management Process
3. Construct the portfolio
 Given the policy statement and the expected conditions,
go about investing
 Allocate available funds to meet goals while managing
risk
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The Portfolio Management Process
4. Monitor and update
 Revise policy statement as needed
 Monitor changing financial and economic conditions
 Evaluate portfolio performance
 Modify portfolio investments accordingly
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The Policy Statement
 Understand and articulate realistic goals
 Know yourself
 Know the risks and potential rewards from investments
 Learn about standards for evaluating portfolio performance
 Know how to judge average performance
 Adjust for risk
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The Policy Statement
 Don’t try to navigate
without a map!
 Important Inputs:
 Investment Objectives
 Investment Constraints
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Investment Objectives
Need to specify return and
risk objectives
 Need to consider the risk
tolerance of the investor
 Return goals need to be
consistent with risk
tolerance
 These will change over
time
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Investment Objectives
Possible broad goals:
 Capital preservation
 Maintain purchasing power
 Minimize the risk of loss
 Capital appreciation
 Achieve portfolio growth through capital gains
 Accept greater risk
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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
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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
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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
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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?
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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.
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Risk/Return History and Asset Allocation
Looking at return data on various asset classes indicate some
important factors for investors:
 Over long time horizons, stocks have always outperformed
low-risk investments.
 So the additional risk of stock investing (higher return
standard deviations) over shorter time horizons seems to all
but disappear over time.
 Need to consider real investment returns over taxes and
costs
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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.
 78% 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
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