Chapter 4Chapter 4
INVESTMENT POLICY STATEMENTS AND ASSET ALLOCATION ISSUES
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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 AvoidanceCan avoid any real chances of lossGenerally a poor strategy except for a part of an overall
portfolio
Risk AnticipationPosition part of your portfolio to protect against
anticipated risk factorsFor example, maintain a cash reserve
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Risk Management Strategies
Risk TransferInsurance 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 ReductionEffective 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
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 statementSpecifies investment goals and acceptable risk levelsThe “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 trendsDetermine strategies that should meet goals within the
expected environmentRequires monitoring and updates since financial
markets are ever-changing
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The Portfolio Management Process
3. Construct the portfolioGiven the policy statement and the expected
conditions, go about investingAllocate available funds to meet goals while managing
risk
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The Portfolio Management Process
4. Monitor and updateRevise policy statement as neededMonitor changing financial and economic conditionsEvaluate portfolio performanceModify portfolio investments accordingly
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The Policy Statement
Understand and articulate realistic goalsKnow yourselfKnow the risks and potential rewards from investments
Learn about standards for evaluating portfolio performanceKnow how to judge average performanceAdjust 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 objectivesNeed to consider the risk
tolerance of the investorReturn 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 powerMinimize the risk of loss
Capital appreciationAchieve portfolio growth through capital gainsAccept greater risk
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Investment Objectives
Current incomeLook to generate income rather than capital gainsMay be preferred in “spending phase”Relatively low risk
Total returnCombining income returns and reinvestment with capital
gainsModerate risk
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Investment Constraints
These factors may limit or at least impact the investment choices:
Liquidity needsHow soon will the money be needed?
Time horizonHow able is the investor to ride out several bad years?
Legal and Regulatory FactorsLegal restrictions often constrain decisionsRetirement regulations
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Investment Constraints
Tax ConcernsRealized capital gains vs. Ordinary income?Taxable vs. Tax-exempt bonds?Regular IRA vs. Roth IRA?401(k) and 403(b) plans
Unique needs and preferencesPerhaps 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 choice8% in equities in Germany, where generous government
pensions and greater risk aversion seem to play a strong role