chapter 17_asset-allocation (1)

8/17/2019 Chapter 17_Asset-Allocation (1)

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Chapter 21: The Investment Process (Asset

Allocation)

Outline:I. Why Asset Allocation?II. Individual Investor Life Cycle.III. Investment Process.

Motivation:- Ris drives return. An a!!ro!riate asset

allocation hel!s investors mana"e theirinvestment ris.

- Individuals# investment o$%ectives andattitudes to&ard investment ris chan"e over

their lifetime. 'herefore( asset allocationshould chan"e over their lifetimeaccordin"ly.

I. Why Asset Allocation?

Asset class: a "rou! of securities that havesimilar characteristics( attri$utes( and ris)returnrelationshi!s.


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Asset allocation: the !rocess of decidin" ho& todistri$ute an investor#s &ealth amon" differentasset classes.

'here are * ty!es of !artici!ants in the !ortfoliomana"ement !rocess:+.Investors: they ran"e from individual investors

to !lan s!onsors. 'hey set their investmento$%ectives. 'hey ty!ically assume

res!onsi$ility for asset allocation. ,am!le:A/ !ension !lan.

0.Portfolio mana"ers: !rofessional mana"ers&ho select securities for investors. /oream!le( an investor may decide to !ut 123of her &ealth into value stocs. 'hen she can

hire a value fund to mana"e the 123 of &ealthin value stocs. ,am!le: /idelity.

1.Consultants: they !rovide assistance onselectin" !ortfolio mana"ers( develo!in" assetallocation !lans( and even evaluatin" !ortfoliomana"ers# !erformance. ,am!le: !ension

consultants and individual investmentadvisors.

*.,valuators: evaluate !ortfolio mana"ers# !erformance. ,am!le: Mornin"star.


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Asset allocation accounts for a lar"e !art of thevaria$ility 456237 in the return on a ty!icalinstitutional !ortfolio8 security selectionaccounts for a trivial !ortion of the varia$ility49+237. iven the im!ortance of assetallocation( it needs to $e ensured that assetallocation !lans are consistent &ith investors#investment o$%ectives.

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Annually( the 'rustees of the Alasa ;tatePension Investment


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have "ood or $ad years. @iversification maes a !ortfolio less risy than the individual assets thatmae it u!. Assets havin" "ood years canmiti"ate the losses of assets havin" $ad years.

'he ideal asset allocation !roduces the $estris)return trade off. Ris is defined as thevaria$ility of returns over time. 'he assetallocation study identifies the most efficient mi

of assets for each level of ris. 'his means thatfor each level of ris( no other mi of assets hasa hi"her return or( for each level of return( noother mi has a lo&er ris. 'his is no&n mostcommonly as the efficient frontier. 'he assetmies on the efficient frontier re!resent the $est

diversified com$inations of the asset classesconsidered in a !articular study.

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;ource: Alasa ;tate Pension Investment


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financial status( future !lans( and ris aversioncharacteristics.

C/A® Which of the follo&in" statements

reflects the im!ortance of the asset allocationdecision to the investment !rocess? 'he assetallocation decision:

a. Bel!s the investor decide on realisticinvestment "oals.

$. Identifies the s!ecific securities to includein a !ortfolio.

c. @etermines most of the !ortfolio#s returnsand volatility over time.

d. Creates a standard $y &hich to esta$lish ana!!ro!riate investment time hori=on.

Ans&er: c.

II. Individual Investor i!e Cycle

o serious investment !lan should $e starteduntil livin" e!enses and a safety net arecovered and develo!ed.


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'he safety net consists of an adeDuate amount of insurance and a cash reserve 4in the form of cashor short-term money instruments7 eDual to a$outsi months# livin" e!enses.

/our Investment Return O$%ectives:+. Ca!ital !reservation: minimi=e the ris ofloss. enerally( this is a strate"y for stron"lyris-averse investors or for funds soon to $e

needed.

0. Ca!ital a!!reciation: investors &ant the !ortfolio to "ro&( mainly throu"h ca!ital "ains(in real terms over time to meet some futureneed.

1. Current income: concentrate on "eneratin"income rather than ca!ital "ains. ,am!le:Retirees.

*. 'otal return: investors &ant the !ortfolio to

"ro&( throu"h $oth reinvestin" current incomeand ca!ital "ains( in real terms over time to meetsome future need. 'otal return#s ris e!osure


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lies $et&een that of the current income andca!ital a!!reciation strate"ies.

/our Life Cycle Phases:+. Accumulation !hase: early-to-middle years of&orin" careers.

- Accumulate assets to satisfy fairlyimmediately needs( e.".( a do&n !ayment for a house( or lon"er-term "oals( e.".(

retirement.- Lon" investment hori=on and stron" future

earnin" a$ility from their salaries means thatthey are a$le to mae moderately hi"h-risinvestments.

- Ca!ital A!!reciation and)or total return.

0. Consolidation !hase: !ast the mid!oint of&orin" careers.

- ,arnin"s eceed e!enses.- 'he ty!ical investment hori=on is still lon"

402-12 years7( so moderate-ris investments

remain attractive.- ;ome concern a$out ca!ital !reservation.- Ca!ital A!!reciation( and)or total return(

and)or ca!ital !reservation.


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1. ;!endin" 4*. iftin"7 !hase: ty!ically $e"ins&hen individuals retire.

- ;ee "reater !rotection of their ca!ital.- ;till need some common stocs for inflation

!rotection.- Plan to "ive ecess assets a&ay.- Current income( and)or total return( and)or

ca!ital !reservation.

III. Investment Process

/our-;te! Portfolio mana"ement Process:+. Construct a !olicy statement: s!ecifies thety!es of riss investors are &illin" to tae and

their investment "oals and constraints.- Possi$ly &ith the assistance of an

investment advisor.- /ocus: investor#s short-term and lon"-term

needs( familiarity &ith ca!ital marethistory( and e!ectations.

- Periodically revie&ed and u!dated $ecauseof the life cycle.

- Provide disci!line and develo! realistic"oals.


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- Create a $enchmar $y &hich to %ud"e the !erformance of the !ortfolio mana"er.

- Bel!s to !rotect the client a"ainst a !ortfoliomana"er#s unethical $ehavior.

0. ;tudy current financial and economicconditions and forecast future trends.

1. Im!lement the !lan $y constructin" the

!ortfolio.- /ocus: meet the investor#s needs at

minimum ris levels.

*. Monitor the !rocess: needs( maretconditions( and !erformance.

C/A® 'he as!ect least liely to $e included in

the !ortfolio mana"ement !rocess is:a. Identifyin" an investor#s o$%ectives(

constraints( and !references. $. Or"ani=in" the mana"ement !rocess itself.c. Im!lementin" strate"ies re"ardin" the

choice of assets to $e used.d. Monitorin" maret condition( relative

values( and investment circumstances.


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Ans&er: $.

C/A® A clearly &ritten investment !olicy

statement is critical for:a. Mutual funds.

$. Individuals.c. Pension funds.d. All investors.

Ans&er: d.

C/A® 'he investment !olicy statement of an

institution must $e concerned &ith all of the

follo&in" except :a. Its o$li"ations to its clients. $. 'he level of the maret.c. Le"al re"ulations.d. 'aation.

Ans&er: $.

;!ecial considerations:


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+. LiDuidity needs. ,am!le: &ealthyindividuals &ith si=a$le ta o$li"ations needadeDuate liDuidity to !ay their taes.

0. 'ime hori=on. A close relationshi! eists $et&een an investor#s 4lon"7 time hori=on( 4lo&7liDuidity needs( and 4"reater7 a$ility to handleris.

1. Le"al and re"ulatory considerations.,am!le: insider tradin" !rohi$itions.

*. niDue !references. ,am!le: sociallyconscious investments.

. 'a concerns. 'aa$le income fromdividends( interests( and rent is taa$le at theinvestor#s mar"inal ta rate. Ca!ital "ains fromasset !rice chan"es are taed only &hen asset issold and the "ain is reali=ed. Currently( ca!ital"ain ta rate is 023 for assets held lon"er than

+E months.

'a-;avin" Fehicles:


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+. Contri$utions to an IRA: ta deducti$le. Allfunds &ithdra&n from an IRA are taa$le ascurrent income.

0. 'he Roth IRA: ta-free &ithdra&s( $ut notta-deducti$le.

1. Cash value of life insurance: accumulates ta-free until the funds are &ithdra&n.

*. Interests on munici!al $onds: eem!ted fromfederal taes 4also !ossi$ly from state taes7.

,am!le: ;u!!ose that a munici!al $ond !aysGH2 annually and has a maret !rice of G+(222.

What is the eDuivalent taa$le yield if theinvestor has a mar"inal ta rate of 0E3?

Munici!al yield annual cou!on)maret !rice H2)+222 H3

,Duivalent taa$le yield munici!al yield)4+ −

mar"inal ta rate7 H3)4+ − 0E37 E.113


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If a similar Duality of cor!orate $ond is currentlyofferin" a yield of E3( then it &ill $e $etter offfor the investor to !urchase the munici!al $ond.

O$%ectives and Constraints of InstitutionalInvestors:

@efined $enefit !ension !lans: !romise to !ayretirees a s!ecific income stream after

retirement.- 'he !lan#s ris is $orne $y the em!loyers.

'hey need to mae u! any shortfall.

@efined contri$ution !ension !lans: do not !romise set $enefits.

- 'he !lan#s ris is $orne $y the em!loyees.

C/A® nder the !rovisions of a ty!ical

cor!orate defined-$enefit !ension !lan( theem!loyer is res!onsi$le for:

a.Payin" $enefits to retired em!loyees. $.Investin" in conservative fi-income assets.c.Counselin" em!loyees in the selection of

asset classes.


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d.Maintainin" an actuarially determined( fullyfunded !ension !lan.

Ans&er: a.

Mutual fund- ,ach mutual fund has its o&n investment

o$%ective( e.".( "ro&th.- '&o $asic constraints: 4+7 those created $y

la& to !rotect investors( and 407 those thatre!resent choices made $y the fundmana"ers.

,ndo&ment funds: arise from contri$utionsmade to charita$le or educational institutions.

- Investment !olicy: a $alance $et&een theor"ani=ation#s need for current income andthe desire to !lan for a "ro&in" stream ofincome in the future to !rotect a"ainstinflation J ty!ically( a total return a!!roach.

- Lon"-term hori=on( little liDuidity

reDuirements( mostly ta-eem!t.- Re"ulatory and le"al constraints arise on the

state level.


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End-of-chapter problem sets: K+( K0( K1( K*( K(KH

chapter 17_asset-allocation (1)

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