CHAPTER 2

THE ASSET ALLOCATION DECISION

LEARNING OUTCOMES

After you read this chapter, you should be able to answer the following questions:
¡ What is involved in the asset allocation process?
¡ What are the four steps in the portfolio management process?
¡ What is the role of asset allocation in investment planning?
¡ Why is a policy statement important to the planning process?
¡ What objectives and constraints should be detailed in a policy statement?
¡ How and why do investment goals change over a person’s lifetime?
¡ Why do asset allocation strategies differ across national boundaries?
¡ Asset allocation is the process of deciding how to distribute an investor’s wealth among
different countries and asset classes for investment purposes.
¡ An asset class is comprised of securities that have similar characteristics, attributes, and
risk/return relationships.
INDIVIDUAL INVESTOR LIFE CYCLE

¡ The Preliminaries
¡ Investment Strategies over an Investor’s Lifetime
¡ Life Cycle Investment Goals
THE PRELIMINARIES

¡ Insurance
- Life insurance protects loved ones against financial hardship should death occur before our
financial goals are met.
- Insurance can also serve more immediate purposes, including being a means to meet long-
term goals, such as retirement planning.
- Insurance coverage also provides protection against other uncertainties.
→ Life insurance should be a component of any financial plan.
 THE PRELIMINARIES

¡ Cash Reserve
- Emergencies, job layoffs, and unforeseen expenses happen, and good investment
opportunities emerge. It is important to have a cash reserve to help meet these occasions.
- In addition to providing a safety cushion, a cash reserve reduces the likelihood of being
forced to sell investments at inopportune times to cover unexpected expenses.
INVESTMENT STRATEGIES OVER AN INVESTOR’S LIFETIME
INVESTMENT STRATEGIES OVER AN INVESTOR’S LIFETIME

¡ Accumulation Phase
- Individuals in the early-to-middle years of their working careers are in the accumulation
phase. They are attempting to accumulate assets to satisfy fairly immediate needs or longer-
term goals.
- As a result of their typically long investment time horizon and their future earning ability,
individuals in the accumulation phase are willing to make relatively high-risk investments in
the hopes of making above-average nominal returns over time.
INVESTMENT STRATEGIES OVER AN INVESTOR’S LIFETIME
 INVESTMENT STRATEGIES OVER AN INVESTOR’S LIFETIME

¡ Consolidation Phase
- Individuals in the consolidation phase are typically past the midpoint of their careers, have
paid off much or all of their outstanding debts.
- The typical investment horizon for this phase is still long, so moderately high risk
investments are attractive.
 INVESTMENT STRATEGIES OVER AN INVESTOR’S LIFETIME

¡ Spending Phase
- The spending phase typically begins when individuals retire. Living expenses are covered by
social security income and income from prior investments, including employer pension plans.
- Although their overall portfolio may be less risky than in the consolidation phase, they still
need some risky growth investments for inflation (purchasing power) protection.
 INVESTMENT STRATEGIES OVER AN INVESTOR’S LIFETIME

¡ Gifting Phase
- The gifting phase is similar to, and may be concurrent with, the spending phase.
- Excess assets can be used to provide financial assistance to relatives or friends, to establish
charitable trusts, or to fund trusts as an estate planning tool to minimize estate taxes.
 LIFE CYCLE INVESTMENT GOALS

¡ Near-term, high-priority goals are shorter-term financial objectives that individuals set to fund
purchases that are personally important to them.
¡ Long-term, high-priority goals typically include some form of financial independence.
¡ Lower-priority goals are just that—it might be nice to meet these objectives, but it is not
critical.
THE PORTFOLIO MANAGEMENT PROCESS
THE PORTFOLIO MANAGEMENT PROCESS

¡ Policy statement is a road map; in it, investors specify the types of risks they are willing to
take and their investment goals and constraints.
¡ The investor’s needs, as reflected in the policy statement, and financial market expectations
will jointly determine investment strategy.
THE NEED FOR A POLICY STATEMENT

¡ Understand and articulate realistic investor goals

¡ Standards for evaluating portfolio performance
¡ Other benefits
INPUT TO THE POLICY STATEMENT

¡ Investment Objectives
¡ Investment Constraints
INVESTMENT OBJECTIVES

¡ The investor’s objectives are his or her investment goals expressed in terms of both risk and
returns.
¡ A careful analysis of the client’s risk tolerance should precede any discussion of return
objectives.
INVESTMENT OBJECTIVES

¡ Capital preservation means that investors want to minimize their risk of loss, usually in real
terms: They seek to maintain the purchasing power of their investment. In other words, the
return needs to be no less than the rate of inflation.
¡ Capital appreciation is an appropriate objective when the investors want the portfolio to
grow in real terms over time to meet some future need. Under this strategy, growth mainly
occurs through capital gains.
INVESTMENT OBJECTIVES

¡ When current income is the return objective, the investors want the portfolio to concentrate
on generating income rather than capital gains.
¡ The objective for the total return strategy is similar to that of capital appreciation; namely,
the investors want the portfolio to grow over time to meet a future need. Whereas the capital
appreciation strategy seeks to do this primarily through capital gains, the total return strategy
seeks to increase portfolio value by both capital gains and reinvesting current income.
INVESTMENT OBJECTIVES

¡ Investment Objective: 25-Year-Old

Invest funds in a variety of moderate- to higher-risk investments. The average risk of the equity
portfolio should exceed that of a broad stock market index, such as the NYSE stock index.
Foreign and domestic equity exposure should range from 80 percent to 95 percent of the total
portfolio. Remaining funds should be invested in short- and intermediate-term notes and bonds.
INVESTMENT OBJECTIVES

¡ Investment Objective: 65-Year-Old

Invest in stock and bond investments to meet income needs (from bond income and stock
dividends) and to provide for real growth (from equities). Fixed-income securities should
comprise 55–65 percent of the total portfolio; of this, 5–15 percent should be invested in short-
term securities for extra liquidity and safety. The remaining 35–45 percent of the portfolio
should be invested in high-quality stocks whose risk is similar to the S&P 500 index.
INVESTMENT CONSTRAINTS

¡ Liquidity needs
¡ Time horizon
- Investors with long investment horizons generally require less liquidity and can tolerate
greater portfolio risk: less liquidity because the funds are not usually needed for many years;
greater risk tolerance because any shortfalls or losses can be overcome by earnings and
returns in subsequent years.
- Investors with shorter time horizons generally favor more liquid and less risky investments
because losses are harder to overcome during a short time frame.
INVESTMENT CONSTRAINTS

¡ Tax concerns
- Taxable income from interest, dividends, or rents is taxable at the investor’s marginal tax rate.
- The marginal tax rate is the part of each additional dollar in income that is paid as tax.
- The average tax rate is simply a person’s total tax payment divided by their total income.
INVESTMENT CONSTRAINTS
 INVESTMENT CONSTRAINTS
¡ Tax concerns
- Capital gains or losses arise from asset price changes. Income is taxed when it is received;
capital gains or losses are taxed only when an asset is sold and the gain or loss, relative to its
initial cost or basis, is realized.
- Unrealized capital gains (or losses) reflect the price change in currently held assets that have
not been sold; the tax liability on unrealized capital gains can be deferred indefinitely.
- Realized capital gains occur when an appreciated asset is sold; taxes are due on the realized
capital gains only.
 INVESTMENT CONSTRAINTS

¡ Tax concerns
- Another tax factor is that some sources of investment income are exempt from federal and
state taxes.
𝐴fter − Tax Income Return = Pre − Tax Income Return x 1 − Marginal Tax Rate

Municipal Yield
Equivalent Taxable Yield =
1 − Marginal Tax Rate
INVESTMENT CONSTRAINTS

¡ Legal and Regulatory Factors

¡ Unique needs and preferences
- Some investors may want to exclude certain investments from their portfolio solely on the
basis of personal preference or for social consciousness reasons.
- Another example of a personal constraint is the time and expertise a person has for managing
his or her portfolio.
CONSTRUCTING THE POLICY STATEMENT

¡ General Guidelines
In the process of constructing a policy statement, investors should think about the set of
questions suggested previously on page 39.
When working with an investor to create a policy statement, an advisor should ensure that the
policy statement satisfactorily answers the questions suggested previously on page 41.
CONSTRUCTING THE POLICY STATEMENT
CONSTRUCTING THE POLICY STATEMENT
CONSTRUCTING THE POLICY STATEMENT

¡ Some Common Mistakes

- Having so much money invested in one asset violates diversification principles and could be
costly.
- Individual investors typically trade stocks too often (driving up commissions), sell stocks
with gains too early (prior to further price increases), and hold on to losers too long (as the
price continues to fall).
THE IMPORTANCE OF ASSET ALLOCATION

In general, there are four decisions involved in constructing an investment strategy:

¡ What asset classes should be considered for investment?
¡ What policy weights should be assigned to each eligible asset class?
¡ What are the allowable allocation ranges based on policy weights?
¡ What specific securities or funds should be purchased for the portfolio?
The asset allocation decision involves the first three points.
THE IMPORTANCE OF ASSET ALLOCATION
THE IMPORTANCE OF ASSET ALLOCATION
THE IMPORTANCE OF ASSET ALLOCATION
THE IMPORTANCE OF ASSET ALLOCATION
THE IMPORTANCE OF ASSET ALLOCATION
THE IMPORTANCE OF ASSET ALLOCATION