The Asset Allocation Decision

1. The Asset Allocation Decision Innovative Financial Instruments Dr. A. DeMaskey Chapter 2

2. Individual Investor:Financial Plan Preliminaries • Insurance • Life insurance • Term life insurance - death benefit only, increasing premium at renewal • Cash value life insurance - death benefit plus savings plan

3. Individual Investor:Financial Plan Preliminaries • Cash reserve • To meet emergency needs • Six-month living expense reserve • Liquid investments • Easily converted to cash without loss of value

4. Individual Investor:Life Cycle • Accumulation phase • Consolidation phase • Spending phase • Gifting phase

5. Life Cycle Investment Goals • Near-term, high-priority goals • Long-term, high-priority goals • Lower-priority goals

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

7. The Portfolio Management Process • Study financial and economic conditions and forecast future trends • determine strategies to meet goals • requires monitoring and updates

8. The Portfolio Management Process • Construct the portfolio • allocate available funds to meet goals and minimize investor’s risks

9. The Portfolio Management Process • Monitor and update • revise policy statement as needed • modify investment strategy accordingly • evaluate portfolio performance

10. The Need For A Policy Statement • Understand and articulate realistic investor goals • needs, objectives, and constraints • financial markets and risks of investing

11. Standards For Evaluating Portfolio Performance • Benchmark portfolio • risk and return • Matches risk preferences and investment needs • analysis of risk tolerance • return objective goals

12. Realistic Investor Goals • Capital preservation • minimize risk of real loss • strongly risk-averse or funds needed soon • Capital appreciation • capital gains to provide real growth over time for future need • aggressive strategy with accepted risk

13. Realistic Investor Goals • Current income • generate spendable funds • Total return • capital gains and income reinvestment • moderate risk exposure

14. Investment Constraints • Liquidity needs • near-term goals • Time horizon • longer time horizon favors risk acceptability • short time horizon favors less risky investments because losses are harder to overcome in a short time frame

15. Investment Constraints • Tax concerns • interest and dividends taxed at investor’s marginal tax rate • capital gains may be unrealized • basis and gain or loss realized • revisions to capital gains tax rates • tradeoff with diversification needs for employer’s stock holdings

16. 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

17. Equivalent Taxable Yield

18. Methods of Tax Deferral • Regular IRA - tax deductible • withdrawals taxable • Roth IRA - not tax deductible • tax-free withdrawals possible • Cash value life insurance • Annuities • Employer’s 401(k) and 403(b) plans

19. Legal and Regulatory Factors • Limitations or penalties on withdrawals • Fiduciary responsibilities • “prudent man” rule • Investment laws prohibit insider trading

20. Unique Needs and Preferences • Personal preferences - socially conscious investments • Time constraints or expertise for managing the portfolio may require professional management • Large investment in employer may require consideration of diversification needs and realistic liquidity • Institutional investors needs

21. 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 importance of diversification

22. 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 • The allowable allocation ranges based on policy weights • What specific securities to purchase for the portfolio • Most of the overall investment return is due to the first two decisions, not the selection of individual investments

23. Returns and Risk of Different Asset Classes • Higher returns compensate for risk • Policy statements must provide risk guidelines • Measuring risk by standard deviation of returns over time indicates stocks are more risky than T-bills

24. 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 risk of T-bills is large because of different expected returns • Focusing only on return variability ignores reinvestment risk • Changes in returns from year to year

25. 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

26. Asset Allocation and Cultural Differences • Social, political, and tax environments • U.S. institutional investors average 45% allocation in equities • In the United Kingdom, equities make up 72% of assets • In Germany, equities are 11% • In Japan, equities are 24% of assets

27. Summary • Develop an investment policy statement • Identify investment needs, risk tolerance, and familiarity with capital markets • Identify objectives and constraints • Investment plans are enhanced by accurate formulation of a policy statement • Asset allocation determines long-run returns and risk • Success depends on construction of the policy statement

28. www.ssa.gov www.ibbotson.com www.mfea.com www.mfea.com/planidx.html www.asec.com www.cccsedu.org/home.html www.aimr.org www.iafp.org www.amercoll.edu www.idfp.org www.napfa.org The Internet:Investments Online

29. Appendix Chapter 2 • Objectives and Constraints of Institutional Investors

30. Mutual Funds • Legal constraints • Investment choices by fund managers

31. Pension Funds • Defined benefit pension plans • actuarial status • liquidity constraint • governed by ERISA • Defined contribution pension plans • liquidity and time horizon • governed by ERISA

32. Endowment Funds • Charitable or educational institutions • need for current income • need for increasing future income

33. Insurance Companies • Life Insurance Companies • earn rate in excess of actuarial rate • growing surplus • limited by fiduciary principles • liquidity needs • tax rule changes

34. Insurance Companies • Nonlife Insurance Companies • cash flows less predictable • fiduciary responsibility to claimants • liquidity concerns • regulation more permissive

35. Banks • Must attract funds in a competitive interest rate environment • tries to maintain a positive difference between its cost of funds and its return on assets • liquidity needs • regulatory constraints