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2
Investment Analysis and PortfolioManagement
First Canadian Edition
By Reilly, Brown, Hedges, Chang
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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
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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
Copyright 2010 Nelson Education Ltd. 2-3
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What is Asset Allocation?
Investor:
Depending on the type of investors,
investment objectives andconstraints vary
Individual investors
Institutional investors
Copyright 2010 Nelson Education Ltd. 2-4
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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
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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
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Phases of an Investors Life Cycle
Copyright 2010 Nelson Education Ltd. 2-7
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Life Cycle Investment Goals
Near-term, high-priority goals
Long-term, high-priority goals Lower-priority goals
Copyright 2010 Nelson Education Ltd. 2-8
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Benefits of Investing Early and Often
Copyright 2010 Nelson Education Ltd. 2-9
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Portfolio Management Process:
Policy Statement
Specifies investment goals and acceptablerisk levels
Should be reviewed periodically
Guides all investment decisions
Copyright 2010 Nelson Education Ltd. 2-10
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Portfolio Management Process
Copyright 2010 Nelson Education Ltd. 2-11
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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?
Copyright 2010 Nelson Education Ltd. 2-12
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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
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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
Copyright 2010 Nelson Education Ltd. 2-14
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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.
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Input to the Policy Statement
Objectives
Risk
Return Constraints
Liquidity, time horizon, tax factors, legal
and regulatory constraints, and uniqueneeds and preferences
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Investment Objectives
Risk Objectives
Should be based on investors ability to
take risk and willingness to take risk
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Investment Objectives
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
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Investment Objectives
Return Objectives
May be stated in terms of an absolute or a
relative percentage return Capital Preservation:
Minimize risk of real losses
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Investment Objectives
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
Copyright 2010 Nelson Education Ltd. 2-20
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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.
Copyright 2010 Nelson Education Ltd. 2-21
I t t C t i t
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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
Copyright 2010 Nelson Education Ltd.
Investment Constraints:
Time
2-22
I t t C t i t
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Investment Constraints:
Taxes and Interest Income
2-23
I t t C t i t
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Investment Constraints:
Taxes and Interest Income
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)
Copyright 2010 Nelson Education Ltd. 2-24
I t t C t i t
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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%
Copyright 2010 Nelson Education Ltd.
Investment Constraints:
Taxes and Interest Income
2-25
I t t C t i t
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Investment Constraints:
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%
Copyright 2010 Nelson Education Ltd. 2-26
I t t C t i t
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Investment Constraints:
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%.
Copyright 2010 Nelson Education Ltd. 2-27
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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
Copyright 2010 Nelson Education Ltd. 2-28
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Tax Free Investments
Earn income that is NOT subject to incometaxes
Tax Free Savings Accounts (TSFA) tax-free investments
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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
Copyright 2010 Nelson Education Ltd. 2-30
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Legal and Regulatory Constraints
Limitations or penalties on withdrawals
Fiduciary responsibilities
The Prudent Investor Rule normallyapply
Investment laws prohibit insidertrading
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Legal and Regulatory Constraints
Institutional investors deserve specialattentions since legal and regulatoryfactors may affect them quitedifferently
Example: banks vs. endowment funds
Copyright 2010 Nelson Education Ltd. 2-32
Personal Constraints
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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
Copyright 2010 Nelson Education Ltd. 2-33
Personal Constraints:
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Personal Constraints:
Unique Needs & Preferences
Large investment in employers stockmay require consideration ofdiversification needs
Institutional investors needs
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Importance of Asset Allocation
Asset Allocation:
process of deciding how to distribute aninvestors wealth among different
countries and asset classes for investmentpurposes
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Importance of Asset Allocation
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
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Importance of Asset Allocation
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According to research studies, most (85 to 95%) ofthe overall investment return is due to the first twodecisions, not the selection of individual investments
Copyright 2010 Nelson Education Ltd.
Importance of Asset Allocation
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Importance of Asset Allocation
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
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Importance of Asset Allocation
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
Copyright 2010 Nelson Education Ltd. 2-40
A t All ti
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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%
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