c02_reilly1ce chapter2 investment analysis and portfolio management

8/22/2019 C02_Reilly1ce Chapter2 Investment Analysis and Portfolio Management

1/41

2

Investment Analysis and PortfolioManagement

First Canadian Edition

By Reilly, Brown, Hedges, Chang


2/41

2 Chapter 2

The Asset Allocation Decision

Individual Investor Life Cycle

The Portfolio Management Process

The Need for Policy Statement

Constructing the Policy Statement

The Importance of Asset Allocation

Copyright 2010 Nelson Education Ltd. 2-2


3/41

What is Asset Allocation?

Asset Allocation

process of deciding how to distribute aninvestors wealth among differentcountries and asset classes for investmentpurposes

Asset Class

group of securities that have similarcharacteristics, attributes, and risk/returnrelationships



4/41

What is Asset Allocation?

Investor:

Depending on the type of investors,

investment objectives andconstraints vary

Individual investors

Institutional investors



5/41

Individual Investor Life Cycle:

Preliminaries

Life Insurance: Providing death benefitsand, 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



6/41

Phases of an Investors Life Cycle

Accumulation phase

Early to middle years of working career

Consolidation phase

Past midpoint of careers. Earnings greaterthan expenses

Spending/Gifting phase

Begins after retirement



7/41

Phases of an Investors Life Cycle



8/41

Life Cycle Investment Goals

Near-term, high-priority goals

Long-term, high-priority goals Lower-priority goals



9/41

Benefits of Investing Early and Often



10/41

Portfolio Management Process:

Policy Statement

Specifies investment goals and acceptablerisk levels

Should be reviewed periodically

Guides all investment decisions



11/41

Portfolio Management Process



12/41

Need for 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 financialmarkets?

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 affectmy investment policy?



13/41

Need for a Policy Statement

Copyright 2010 Nelson Education Ltd.

Sets standards for evaluating portfolio

performance Provides a comparison standard in judging the performance

of the portfolio manager Benchmark portfolio or comparison standard is used to

reflect the risk an return objectives specified in the policy

statement

Should act as a starting point for periodic portfolio reviewand client communication with the manager

2-13


14/41

Need for a Policy Statement

Other Benefits Reduces possibility of inappropriate or unethical

behaviour of the portfolio manager

Helps create seamless transition from one moneymanager to another without costly delays

Provides the framework to help resolve anypotential disagreements between the client and

the manager



15/41

Input to the Policy Statement

Constructing the policy statement beginswith a profile analysis of the investorscurrent and future financial situations and a

discussion of investment objectives andconstraints.



16/41

Input to the Policy Statement

Objectives

Risk

Return Constraints

Liquidity, time horizon, tax factors, legal

and regulatory constraints, and uniqueneeds and preferences



17/41

Investment Objectives

Risk Objectives

Should be based on investors ability to

take risk and willingness to take risk



18/41


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

Careful analysis of clients risk tolerance

should precede any discussion of returnobjectives



19/41


Return Objectives

May be stated in terms of an absolute or a

relative percentage return Capital Preservation:

Minimize risk of real losses



20/41


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



21/41

Investment Constraints:

Liquidity

Liquidity

Vary between investors depending upon age,employment, tax status, etc.

Planned vacation expenses and house downpayment are some of the liquidity needs.


I t t C t i t


22/41

Time

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



Time

2-22

I t t C t i t


23/41


Taxes and Interest Income

2-23

I t t C t i t


24/41



Interest Income: 100% of all interest income istaxed at an investors marginal tax rate inCanada.

Assuming a marginal tax rate of 26%, an investorthat receives $2,000 in interest income will havea $520 tax liability ($2,000 X 26%)

After Tax Return on Investment (AT -ROI)

AT - ROI = Pre-tax ROI X ( 1 Marginal Tax Rate)


I t t C t i t


25/41

Interest Income: 100% of all interest income istaxed at an investors marginal tax rate inCanada.

So an investor if you received $2,000 interestincome on a $100,000 investment that would bea 2% ROI on a pre-tax basis

After Tax Return on Investment (AT -ROI)

AT ROI = Pre-Tax ROI X ( 1 Marginal Tax Rate)

AT - ROI = 2% X ( 1 .26 ) = 1.48%




2-25

I t t C t i t


26/41


Taxes and Dividends

The Dividend Tax Credit Calculation

Dividend Income $2,000

Div. Tax Credit Gross Up (145%) $2,900

Fed. Tax on Grossed Up Div. (26%) $754

($2,900 X 26%)

Fed. Div. Tax on Grossed Up Div. (18.97%) $550($2,900 X 18.97%)

Net Fed. Taxes on Dividends $204($754 - $550)

Effective Tax Rate on Dividends 10.20%($204 $2,000)

Assuming a marginal tax rate of 26%, the dividend tax crediteffectively reduced the effective tax rate by about 60%


I t t C t i t


27/41


Taxes and Capital Gains

Capital gains are also taxed at an effectively lower tax ratebecause only 50% of a gain is taxed in Canada

Capital Gains Exclusion and Income Taxes

Capital Gain $2,000

Cap. Gains Exclusion Rate (50%) $1,000(50% X $2,000)

Tax on Taxable Cap. Gains (26%) $260

Effective Tax Rate on Cap. Gains 13%($260 $2,000)

Assuming a marginal tax rate of 26%, the effective taxrate on capital gains is 50% of the marginal rate or in thiscase 13%.



28/41

Investment Constraints

Taxes Unrealized capital gains: Reflect price

appreciation of currently held assets that have

not yet been sold Realized capital gains: When the asset has been

sold at a profit

Trade-off between taxes and diversification: Tax

consequences of selling company stock fordiversification purposes



29/41

Tax Free Investments

Earn income that is NOT subject to incometaxes

Tax Free Savings Accounts (TSFA) tax-free investments



30/41

Tax Deferred Investments

Tax deferred investments

compound tax free but when withdrawn aresubject to taxes

Registered Retirement Savings Accounts(RRSP)

individuals can deposit money into and earnedtax deferred income

At withdrawal, all funds are subject to tax



31/41

Legal and Regulatory Constraints

Limitations or penalties on withdrawals

Fiduciary responsibilities

The Prudent Investor Rule normallyapply

Investment laws prohibit insidertrading



32/41

Legal and Regulatory Constraints

Institutional investors deserve specialattentions since legal and regulatoryfactors may affect them quitedifferently

Example: banks vs. endowment funds


Personal Constraints


33/41

Personal Constraints:

Unique Needs & Preferences

Personal preferences such as sociallyconscious investments could influenceinvestment choice

Time constraints or lack of expertisefor managing the portfolio may requireprofessional management




34/41


Unique Needs & Preferences

Large investment in employers stockmay require consideration ofdiversification needs

Institutional investors needs



35/41

Importance of Asset Allocation

Asset Allocation:

process of deciding how to distribute aninvestors wealth among different

countries and asset classes for investmentpurposes



36/41


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



37/41




38/41

According to research studies, most (85 to 95%) ofthe overall investment return is due to the first twodecisions, not the selection of individual investments



2-38


39/41


Historically, small company stocks havegenerated the highest returns, so have thevolatility

Inflation and taxes have a major impact onreturns

Returns on Treasury Bills have barely keptpace with inflation



40/41


Measuring risk by the probability of not meeting your investmentreturn 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 ignoresreinvestment risk


A t All ti


41/41

Asset Allocation

and Cultural Differences

Social, political, and tax environmentsinfluence the asset allocation decision

Equity allocations of U.S. pension fundsaverage 58%

In the United Kingdom, equities make up78% of assets

In Germany, equity allocation averages 8%

C i h 2010 N l Ed i L d 2 41

c02_reilly1ce chapter2 investment analysis and portfolio management

Documents