Investment Analysis and

Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown

Chapter 2
 Chapter 2
The Asset Allocation Decision
Questions to be answered:
• What is asset allocation?
• 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?
 Chapter 2
The Asset Allocation Decision
• What objectives and constraints should
be detailed in a policy statement?
• How and why do investment goals change
over a person’s lifetime and
circumstances?
• Why do asset allocation strategies differ
across national boundaries?
 Chapter 2
The Asset Allocation Decision
• What objectives and constraints should
be detailed in a policy statement?
• How and why do investment goals change
over a person’s lifetime and
circumstances?
• Why do asset allocation strategies differ
across national boundaries?
 Asset Allocation
Asset Allocation:
Is the process of determining how to
apportion an investors wealth among
asset classes and different countries.
Asset allocation is a key component to
the portfolio management process.
Financial Plan Preliminaries
Insurance
– Health insurance
– Disability insurance
– Automobile insurance
– Home/rental insurance
– Liability insurance
Financial Plan Preliminaries
Cash reserve
– To meet emergency needs
– Includes cash equivalents (liquid
investments)
– Equal to six months living expenses
recommended by experts
 Individual Investor
Life Cycle
• Accumulation phase – early to middle
years of working career
• Consolidation phase – past midpoint of
careers. Earnings greater than
expenses
• Spending/Gifting phase – begins after
retirement
 Individual Investor Life Cycle
Net Worth Exhibit 2.1

Accumulation Consolidation Phase Spending Phase

Phase Gifting Phase
Long-term:
Long-term: Retirement Long-term:
Retirement Estate
Short-term:
Children’s Planning
college Vacations
Short-term:
Short-term: Children’s College Lifestyle
House Needs Gifts
Car

Age
25 35 45 55 65 75
Life Cycle Investment Goals

• Near-term, high-priority goals

• Long-term, high-priority goals

• Lower-priority goals
 Exhibit 2.2

The Portfolio Management Process

1. Policy statement - Focus: Investor’s short-term and long-
term needs, familiarity with capital market history, and
expectations
2. Examine current and project financial, economic,
political, and social conditions - Focus: Short-term and
intermediate-term expected conditions to use in
constructing a specific portfolio
3. Implement the plan by constructing the portfolio -
Focus: Meet the investor’s needs at the minimum risk
levels

4. Feedback loop: Monitor and update investor needs,

environmental conditions, portfolio performance
The Portfolio Management Process

1. Policy statement
– specifies investment goals and
acceptable risk levels
– should be reviewed periodically
– guides all investment decisions
The Portfolio Management Process

2. Study current financial and

economic conditions and forecast
future trends
– determine strategies to meet goals
– requires monitoring and updating
The Portfolio Management Process

3. Construct the portfolio

– allocate available funds to minimize
investor’s risks and meet investment
goals
The Portfolio Management Process

4. Monitor and update

– evaluate portfolio performance
– Monitor investor’s needs and market
conditions
– revise policy statement as needed
– modify investment strategy
accordingly
 Why The Need For A Policy
Statement
• Helps investors understand their own
needs, objectives, and investment
constraints
• Sets standards for evaluating portfolio
performance
• Reduces the possibility of
inappropriate behavior on the part of
the portfolio manager
 Constructing A Policy Statement

Questions to be answered:
• What are the real risks of an adverse financial
outcome, especially in the short run?
• What probable emotional reactions will I have to
an adverse financial outcome?
• How knowledgeable am I about investments and
the financial markets?
 Constructing A Policy Statement
• What other capital or income sources do I
have? How important is this particular
portfolio to my overall financial position?
• What, if any, unanticipated consequences of
interim fluctuations in portfolio value might
affect my investment policy?
 Investment Objectives
• Risk Tolerance
• Absolute or relative percentage
return
• General goals
 Investment Objectives
General Goals
1. Capital preservation
1. minimize risk of real loss
2. Capital appreciation
1. Growth of the portfolio in real terms to meet
future need
3. Current income
1. Focus is in generating income rather than
capital gains
 Investment Objectives
General Goals
4. Total return
– Increase portfolio value by capital gains and by
reinvesting current income
– Maintain moderate risk exposure
Risk Categories & Suggest Asset
Allocation
 Investment Constraints
• Liquidity needs
– Vary between investors depending upon age,
employment, tax status, etc.
• Time horizon
– Influences liquidity needs and risk tolerance
 Investment Constraints
• Tax concerns
– Capital gains or losses – taxed differently from
income
– Unrealized capital gain – reflect price
appreciation of currently held assets that have
not yet been sold
– Realized capital gain – when the asset has been
sold at a profit
– Trade-off between taxes and diversification –
tax consequences of selling company stock for
diversification purposes
 Investment Constraints
• Tax concerns (continued)
– interest on municipal bonds exempt from
federal income tax and from state of issue
– interest on federal securities exempt from state
income tax
– contributions to an IRA may qualify as
deductible from taxable income
– tax deferral considerations - compounding
 After Tax Return on a Taxable
Investment
After – Tax Return =

Pre Tax Return ( 1- Marginal Tax Rate)

The following Slide is for a person in the 28% marginal

tax bracket.
 Effect of Tax Deferral on
Investor Wealth over Time
Exhibit 2.6
Investment $10,062.66
Value 8% Tax
Deferred

$5,365.91
5.76%
After Tax
Return
$1,000

Time
0 10 20 30 years
 Effect of Tax Deferral on
Investor Wealth over Time
Problem:
.a. Someone in the 36 percent tax bracket can earn 9
percent annually on her investments in a tax exempt
IRA account. What will be the value of a one-time $10,000
investment in five years? Ten years? Twenty years?

b. Suppose the preceding 9 percent return is taxable rather

than tax-deferred and the taxes are paid annually.
What will be the after-tax value of her $10,000 investment
after 5, 10, and 20 years?
Means to Reduce Tax Liability
• Regular IRA - tax deductible
– Tax on returns deferred until withdrawal
• Roth IRA - not tax deductible
– tax-free withdrawals possible
• Cash value life insurance – funds accumulate tax-
free until they are withdrawn
Legal and Regulatory Factors
• Limitations or penalties on withdrawals
Example: Funds removed from a regular IRA account
before the age of 59.5 are taxable and subject to an
additional 10% withdrawal penalty.
• Investment laws prohibit insider trading
Unique Needs and Preferences
• Personal preferences such as socially conscious
investments could influence investment choice
• Time constraints or lack of expertise for managing
the portfolio may require professional
management
• Large investment in employer’s stock may require
consideration of diversification needs
• Institutional investors needs
Constructing the Policy Statement
• Objectives - risk and return
• Constraints - liquidity, time horizon, tax
factors, legal and regulatory constraints, and
unique needs and preferences
• Developing a plan depends on
understanding the relationship between risk
and return and the the importance of
diversification
 The Importance
of Asset Allocation
• An investment strategy is based on four
decisions
– What asset classes to consider for investment
– What normal or policy weights to assign to each
eligible class
– Determining the allowable allocation ranges
based on policy weights
– What specific securities to purchase for the
portfolio
 The Importance
of Asset Allocation

• According to research studies, most (85% to

95%) of the overall investment return is due
to the first two decisions, not the selection
of individual investments
Returns and Risk of Different
Asset Classes
• Historically, small company stocks have
generated the highest returns. But the
volatility of returns have been the highest
too
• Inflation and taxes have a major impact on
returns
• Returns on Treasury Bills have barely kept
pace with inflation
Returns and Risk of Different
Asset Classes
• Measuring risk by probability of not
meeting your investment return 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 ignores reinvestment risk
Asset Allocation Summary
• Policy statement determines types of assets
to include in portfolio
• Asset allocation determines portfolio return
more than stock selection
• Over long time periods, sizable allocation to
equity will improve results
• Risk of a strategy depends on the investor’s
goals and time horizon
 Asset Allocation and
Cultural Differences
• Social, political, and tax environments influence
the asset allocation decision
• Equity allocations of U.S. pension funds average
58%
• In the United Kingdom, equities make up 78% of
assets
• In Germany, equity allocation averages 8%
• In Japan, equities are 37% of assets
 Summary
• Identify investment needs, risk tolerance, and
familiarity with capital markets
• Identify objectives and constraints
• Enhance investment plans by accurate
formulation of a policy statement
• Focus on asset allocation as it determines long-
term returns and risk
 The Internet
Investments Online
www.ssa.gov www.amercoll.edu
www.ibbotson.com www.idfp.org
www.mfea.com www.napfa.org
www.mfea.com/planidx.html
www.asec.com
www.cccsedu.org/home.html
www.aimr.org
www.iafp.org
 Appendix
Objectives and Constraints of
Institutional Investors

• Mutual Funds – pool investors funds and

invests them in financial assets as per its
investment objective
 Pension Funds
• Receive contributions from the firm, its
employees, or both and invests those funds
• Defined Benefit – promise to pay retirees
a specific income stream after retirement
• Defined Contribution – do not promise a
set of benefits. Employees’ retirement
income is not an obligation of the firm
 Endowment Funds
They represent contributions made to
charitable or educational institutions
 Insurance Companies
• Life Insurance Companies
– earn rate in excess of actuarial rate
– growing surplus if the spread is positive
– fiduciary principles limit the risk tolerance
– liquidity needs have increased
– tax rule changes
 Insurance Companies
• Nonlife Insurance Companies
– cash flows less predictable
– fiduciary responsibility to claimants
– Risk exposure low to moderate
– liquidity concerns due to uncertain claim
patterns
– regulation more permissive
 Banks
• Must attract funds in a competitive
interest rate environment
• Try to maintain a positive difference
between their cost of funds and their
return on assets
• Need substantial liquidity to meet
withdrawals and loan demands
• Face regulatory constraints
 Future topics
Chapter 3
• Investment choices
• Including global assets in asset
allocation decisions