Chapter 4Chapter 4

INVESTMENT POLICY STATEMENTS AND ASSET ALLOCATION ISSUES

1.2Investments Chapter 4

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?

1.3Investments Chapter 4

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.

1.4Investments Chapter 4

Managing Risk

Since risk drives expected return, investing involves managing risk rather than managing return.

1.5Investments Chapter 4

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

1.6Investments Chapter 4

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.

1.7Investments Chapter 4

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

1.8Investments Chapter 4

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

1.9Investments Chapter 4

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

1.10Investments Chapter 4

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

1.11Investments Chapter 4

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

1.12Investments Chapter 4

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

1.13Investments Chapter 4

The Portfolio Management Process

1. Policy statementSpecifies investment goals and acceptable risk levelsThe “road map” that guides all investment decisions

1.14Investments Chapter 4

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

1.15Investments Chapter 4

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

1.16Investments Chapter 4

The Portfolio Management Process

4. Monitor and updateRevise policy statement as neededMonitor changing financial and economic conditionsEvaluate portfolio performanceModify portfolio investments accordingly

1.17Investments Chapter 4

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

1.18Investments Chapter 4

The Policy Statement

Don’t try to navigate without a map!

Important Inputs:Investment Objectives Investment Constraints

1.19Investments Chapter 4

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

1.20Investments Chapter 4

Investment Objectives

Possible broad goals: Capital preservation

Maintain purchasing powerMinimize the risk of loss

Capital appreciationAchieve portfolio growth through capital gainsAccept greater risk

1.21Investments Chapter 4

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

1.22Investments Chapter 4

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

1.23Investments Chapter 4

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

1.24Investments Chapter 4

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?

1.25Investments Chapter 4

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.

1.26Investments Chapter 4

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

1.27Investments Chapter 4

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