Transcript Lecture Presentation to accompany Investment Analysis

The Asset Allocation
Decision
Innovative Financial Instruments
Dr. A. DeMaskey
Chapter 2
Individual Investor:
Financial Plan Preliminaries
Insurance
Life insurance
Term life insurance - death benefit only,
increasing premium at renewal
Cash value life insurance - death benefit plus
savings plan
Individual Investor:
Financial Plan Preliminaries
Cash reserve
To meet emergency needs
Six-month living expense reserve
Liquid investments
Easily converted to cash without loss of value
Individual Investor:
Life Cycle
Accumulation phase
Consolidation phase
Spending phase
Gifting phase
Life Cycle Investment
Goals
Near-term, high-priority goals
Long-term, high-priority goals
Lower-priority goals
The Portfolio Management
Process
 Policy statement
• specifies investment goals and
acceptable risk levels
• should be reviewed periodically
• guides all investment decisions
The Portfolio Management
Process
 Study financial and economic
conditions and forecast future
trends
• determine strategies to meet goals
• requires monitoring and updates
The Portfolio Management
Process
 Construct the portfolio
• allocate available funds to meet
goals and minimize investor’s risks
The Portfolio Management
Process
 Monitor and update
• revise policy statement as needed
• modify investment strategy
accordingly
• evaluate portfolio performance
The Need For A Policy
Statement
Understand and articulate realistic
investor goals
needs, objectives, and constraints
financial markets and risks of investing
Standards For Evaluating
Portfolio Performance
Benchmark portfolio
risk and return
Matches risk preferences and
investment needs
analysis of risk tolerance
return objective goals
Realistic Investor Goals
Capital preservation
minimize risk of real loss
strongly risk-averse or funds needed soon
Capital appreciation
capital gains to provide real growth over
time for future need
aggressive strategy with accepted risk
Realistic Investor Goals
Current income
generate spendable funds
Total return
capital gains and income reinvestment
moderate risk exposure
Investment Constraints
Liquidity needs
near-term goals
Time horizon
longer time horizon favors risk
acceptability
short time horizon favors less risky
investments because losses are harder to
overcome in a short time frame
Investment Constraints
Tax concerns
interest and dividends taxed at investor’s
marginal tax rate
capital gains may be unrealized
basis and gain or loss realized
revisions to capital gains tax rates
tradeoff with diversification needs for
employer’s stock holdings
Investment Constraints
Tax concerns (continued)
interest on municipal bonds exempt from
federal income tax and from state of issue
interest on federal securities exempt from
state income tax
contributions to an IRA may qualify as
deductible from taxable income
tax deferral considerations - compounding
Equivalent Taxable Yield
MunicipalYield
ET Y 
1  MarginalT ax Rate
Methods of Tax Deferral
Regular IRA - tax deductible
withdrawals taxable
Roth IRA - not tax deductible
tax-free withdrawals possible
Cash value life insurance
Annuities
Employer’s 401(k) and 403(b) plans
Legal and Regulatory
Factors
Limitations or penalties on withdrawals
Fiduciary responsibilities
“prudent man” rule
Investment laws prohibit insider trading
Unique Needs and
Preferences
Personal preferences - socially
conscious investments
Time constraints or expertise for
managing the portfolio may require
professional management
Large investment in employer may
require consideration of diversification
needs and realistic liquidity
Institutional investors needs
Constructing the Policy
Statement
Objectives - risk and return
Constraints - liquidity, time horizon, tax
factors, legal and regulatory constraints,
and unique needs and preferences
Developing a plan depends on
understanding the relationship between
risk and return and the importance of
diversification
The Importance
of Asset Allocation
An investment strategy is based on four decisions
What asset classes to consider for investment
What normal or policy weights to assign to each
eligible class
The allowable allocation ranges based on policy
weights
What specific securities to purchase for the
portfolio
Most of the overall investment return is due to the
first two decisions, not the selection of individual
investments
Returns and Risk of
Different Asset Classes
Higher returns compensate for risk
Policy statements must provide risk
guidelines
Measuring risk by standard deviation of
returns over time indicates stocks are
more risky than T-bills
Returns and Risk of
Different Asset Classes
Measuring risk by probability of not
meeting your investment return
objective indicates risk of equities is
small and risk of T-bills is large because
of different expected returns
Focusing only on return variability
ignores reinvestment risk
Changes in returns from year to year
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
investor’s goals and time horizon
Asset Allocation and
Cultural Differences
Social, political, and tax environments
U.S. institutional investors average 45%
allocation in equities
In the United Kingdom, equities make up
72% of assets
In Germany, equities are 11%
In Japan, equities are 24% of assets
Summary
Develop an investment policy statement
Identify investment needs, risk tolerance,
and familiarity with capital markets
Identify objectives and constraints
Investment plans are enhanced by
accurate formulation of a policy statement
Asset allocation determines long-run
returns and risk
Success depends on construction of the
policy statement
The Internet:
Investments Online
www.ssa.gov
www.ibbotson.com
www.mfea.com
www.mfea.com/plani
dx.html
www.asec.com
www.cccsedu.org/ho
me.html
www.aimr.org
www.iafp.org
www.amercoll.edu
www.idfp.org
www.napfa.org
Appendix Chapter 2
Objectives and Constraints
of Institutional Investors
Mutual Funds
Legal constraints
Investment choices by fund managers
Pension Funds
Defined benefit pension plans
actuarial status
liquidity constraint
governed by ERISA
Defined contribution pension plans
liquidity and time horizon
governed by ERISA
Endowment Funds
Charitable or educational institutions
need for current income
need for increasing future income
Insurance Companies
Life Insurance Companies
earn rate in excess of actuarial rate
growing surplus
limited by fiduciary principles
liquidity needs
 tax rule changes
Insurance Companies
Nonlife Insurance Companies
cash flows less predictable
fiduciary responsibility to claimants
liquidity concerns
regulation more permissive
Banks
Must attract funds in a competitive
interest rate environment
tries to maintain a positive difference
between its cost of funds and its return on
assets
liquidity needs
regulatory constraints