Asset Allocation Decisions (1)

7/26/2019 Asset Allocation Decisions (1)

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Chapter IIAsset Allocation Decision

6/11/16 Dr. Tekeste B, Department ofAccounting and Finance

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Chapter outline

Asset allocation

Inestor!s life c"cle

#ortfolio inestment process


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Asset allocation

Asset allocation

oThe process of deciding ho% to distri&ute an inestor!s %ealthamong di'erent asset classes.

oA strateg" of inesting that is designed to reduce the aria&ilit"of returns &" diersif"ing across a ariet" of inestments orasset classes.

(Asset classes ) a group of securities that hae similarcharacteristics, attri&utes, and risk/return relationships)

oFi*ed income assets +Bonds

oe-uit" +common stocks and

ocash e-uialents +arketa&le securities

(#ortfolio ) a mi* of asset classes, e.g. 60 2 # 3 and 40&onds


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Cntd.

Asset allocation, not securit" selection andmarket timing, is the primar" determinant ofthe ariation in portfolio returns)

o780 of the ariation in portfolio returns isaccounted &" asset allocation

o910 of the ariation in portfolio returns ise*plained &" securit" selection.

#roper asset allocation decision+diersi:cation makes the portfolio less risk"than the indiidual assets that make it up.


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;e


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4$@ear ;isk/;eturn

Anal"sis

ach dot assetclass

#ortfolio ami*ture of asset

classes

Ideal riskand

return

one


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Diersi:cation



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Asset allocation

In asset allocation decisions muchemphasis is gien to the correlationamong the asset classes in the portfolio.

oGigh correlation or lo% correlation>

#ossi&le alues of correlation)

1. #erfect correlation takes the alue of 1

or @1

$. Ho correlation takes the alue


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Illustration correlation

e'ect

lets imagine that we engage in a typical

asset allocation decision and invest$20,000 divided equally between avolatile investment (red line) that goesup and down, say up 12 percent one

month and down 8 percent the net, andthen combine it with a steadierinvestment (green line) that goes up anddown hal! as much (up " percent one

month and down # percent the net)6/11/16 Dr. Tekeste B, Department ofAccounting and Finance 1


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G"pothetical e*ample


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Jan Fe& .ar Apr .a" Jun Jul Aug ep Kct Ho Dec

@1/0

@30

/0

30

1/0

130

Inestment A Inestmet B Com&ined inestment


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Asset allocation

Lien the importance of asset allocation,it needs to &e ensured that assetallocation plans are consistent %ith

inestors! inestment o&Mecties. Indiidual inestors! inestment needs

are a'ected &" their ages, :nancialstatus, future plans, and risk aersion

characteristics.


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;efresher

In "our "oung age

%ould "ou prefer toinest in e-uities

or :*ed incomeassets> =h">


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II. Individual Investor Life Cycle

Inestment plan)oliing e*penses are coered

oA safet" net is deeloped.

The safet" net consists of an ade-uateamount of insurance and a cash resere+in the form of cash or short@term mone"instruments e-ual to a&out si* months!

liing e*penses.



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Cont!d

Four Inestment ;eturn K&Mecties)

1. Capital preseration +sta&ilit") minimie the risk of loss

$. Capital appreciation +gro%th) gro%th of portfolio,mainl" through capital gains, in real terms oer time to

meet some future need.5. Current income +income) periodic income, rather than

capital gains, *ample) ;etirees.

4. Total return) reinesting current income and capitalgains, in real terms oer time to meet some futureneed.

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Individual Investors

Life CycleAccumulation phase

Consolidation phase

pending phase

Lifting phase


I di id l I t Lif


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Individual Investor LifeCycle

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Net Worth

Age

Accumulation

Phase

Long-term:

RetirementChildrens college

Short-term:

House Car

Consolidation Phase

Long-term:

Retirement

Short-term:

Vacations

Childrens College

Spending Phase

Gifting Phase

Long-term:

Estate Planning

Short-term:

Lifestle !eeds

Gifts

Figure 2.1



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Cont!d

1. Accumulation phase) earl"@to@middle"ears of %orking careers.

Accumulate assets to satisf" fairl"

immediatel" needs, e.g., a do%n pa"mentfor a house, or longer@term goals, e.g.,retirement.

?ong inestment horion and strong future

earning a&ilit" from their salaries meansthat the" are a&le to make moderatel" high@risk inestments.

Capital Appreciation and/or total return.



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Cont!d

$. Consolidation phase) past the midpointof %orking careers.

arnings e*ceed e*penses.

The t"pical inestment horion is still long+$@5 "ears, so moderate@risk inestmentsremain attractie.

ome concern a&out capital preseration.

Capital Appreciation, and/or total return,and/or capital preseration.



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Cont!d

5. pending +4. Lifting phase) t"picall"&egins %hen indiiduals retire.

eek greater protection of their capital.

till need some common stocks for in


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III. The Portfolio Investment Process

Four@tep #ortfolio management #rocess)1. Construct a policy statement:

speci:es the t"pes of risks inestors are%illing to take and their inestment goalsand constraints.



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Cont!d

#olic" tatement) #roide discipline and deelop realistic

goals. helps the inestor to specif" realistic goals and

&ecome more informed a&out the risks and costs ofinesting

Create a &enchmark &" %hich to Mudge the

performance of the portfolio manager. Gelps to protect the client against a portfolio

manager!s unethical &ehaior.



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Cont!d

$. tud" current :nancial and economicconditions and forecast future trends.

@ The inestor!s needs, as re


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Cont!d

4. onitor and update

o;eise polic" statement asneeded

oodif" inestment strateg"

accordingl"o;e&alance portfolio

oaluate portfolio performance256/11/16 Dr. Tekeste B, Department of

Accounting and Finance


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ummar" on Asset

allocation =hen &uilt correctl", a multi@assetportfolio achiees e-uit"@like returns %ith&ond@like risks

Asset allocation +diersi:cation) O Don!tput all "our eggs in one &asketP

Asset allocation re-uires)

oDepthoBreadth

o#ortfolio +&lended assets has s"nerg"


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#ortfolio has s"nerg"

+Qcient frontier


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Comparison) &et%eenindiidual asset and multi@

asset portfolio


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Annual returns for multi@

Asset portfolio


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ulti@asset s single asset

For ho%man" "ears

does a singleasset &it theaggregateportfolio> Aoid

largelosses

;educethe

fre-uenc"of losses


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Asset allocation

6/11/16 Dr. Tekeste B, Department ofA ti d Fi

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