Chapter 2 The Asset Allocation Decision

1. Chapter 2 The Asset Allocation Decision

2. Individual Investor Life Cycle Exhibit 2.1 Net Worth Consolidation Phase Long-term: Retirement Short-term: Vacations Children’s College Accumulation Phase Long-term: Retirement Children’s college Short-term: House Car Spending Phase Gifting Phase Long-term: Estate Planning Short-term: Lifestyle Needs Gifts Age

3. The Portfolio Management Process Exhibit 2.2 1. Policy statement (road map)- Focus: Investor’s short-term and long-term needs, familiarity with capital market history, and expectations 2. Examine current and projected 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

4. 投資決策過程 來源:徐俊明, 投資學理論與實務, 4版

5. Input to the policy statement • Investment objectives expressed in terms of risk and return: • Risk Tolerance • Psychological makeup • Insurance coverage • Cash reserves • Family situation • Age • Current net worth • Income expectations

6. Investment objectives expressed in terms of risk and return: • Return objective • Absolute or relative percentage return • General goals

7. General Goals • Capital preservation • minimize risk of real loss • Capital appreciation • Growth of the portfolio in real terms to meet future need

8. General Goals • Total return • Increase portfolio value by capital gains and by reinvesting current income • Maintain moderate risk exposure • Income generation • Focus is in generating income rather than capital gains

9. Risk Categories and Suggested Asset Allocations for Merrill Lynch Clients Exhibit 2.3

10. Risk Categories and Suggested Asset Allocations for Merrill Lynch Clients Exhibit 2.3

11. How Much Risk is Right for You? Exhibit 2.4

12. Investment Constraints • Liquidity needs • Vary between investors depending upon age, employment, tax status, etc. • Time horizon • Influences liquidity needs and risk tolerance (longer time horizon faces less liquidity and larger risk)

13. Investment Constraints • Tax concerns • Capital gains/losses or income distributions? • Unrealized vs realized capital gain • Trade-off between taxes and diversification (use employee payroll deduction plans or 401k to buy company stocks)

14. 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

15. Equivalent Taxable Yield

16. Effect of Tax Deferral on Investor Wealth over Time Exhibit 2.6 Investment Value $10,062.66 $5,365.91 $1,000 Time Marginal tax=28%, after-tax return=5.76%=8%×(1-28%)

17. Methods of Tax Deferral (for US) • Regular IRA – contributions tax deductible • Tax on returns deferred until withdrawal • Roth IRA – contributions not tax deductible • tax-free on returns possible • Cash value life insurance – funds accumulate tax-free until they are withdrawn • Tax Sheltered Annuities • Employer’s 401(k) and 403(b) plans – tax-deferred investments

18. Exhibit 2.9 Historical Average Annual Returns and Return Variability, 1926-2001

19. Over Long Time Periods, Equities Offer Higher Returns Exhibit 2.10

20. Returns and Risk of Different Asset Classes • Historically, small company stocks have generated the higher returns. But the volatility of returns have been higher too. • Inflation and taxes have a major impact on returns. • Returns on Treasury Bills have barely kept pace with inflation.

21. Extra reading: Appendix of Chapter 2: Objectives and Constraints of Institutional Investors (pages 63-66) • Mutual Funds • Pension funds • Endowment funds • Insurance companies • Banks