Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. Brown

1. Investment Analysis and Portfolio ManagementEighth Editionby Frank K. Reilly & Keith C. Brown Chapter 2

2. Chapter 2The 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?

3. Chapter 2The 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?

4. Financial Plan Preliminaries Insurance • Life insurance • Term life insurance - Provides death benefit only. Premium will change every renewal period • Universal and variable life insurance – provide cash value plus death benefit

5. Financial Plan Preliminaries Insurance • Health insurance • Disability insurance • Automobile insurance • Home/rental insurance • Liability insurance

6. Financial Plan Preliminaries Cash reserve • To meet emergency needs • Includes cash equivalents (liquid investments) • Recommendation: Equal to six months living expenses

7. Individual InvestorLife Cycle • Three phases to an Investor’s life cycle: • Accumulation phase – early to middle years of working career • Consolidation phase – past midpoint of career. Earnings greater than expenses • Spending/Gifting phase – begins after retirement • Desires & constraints will change as one moves through the different stages

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

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

10. Exhibit 2.3 The Portfolio Management Process 1. InvestmentPolicy statement - 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 with the minimum amount of risk 4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performance

11. Why An Investment 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

12. Constructing An Investment Policy Statement Questions to be answered: • What are the risks of an adverse financial outcome, especially in the short run? • What emotional reactions will I have to an adverse financial outcome? • How knowledgeable am I about investments and the financial markets?

13. Constructing An Investment 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, legal restrictions may affect my investment needs? • What, if any, unanticipated consequences of interim fluctuations in portfolio value might affect my investment policy?

14. Investment Objectives • Return (Absolute or relative percentage return) • Risk Tolerance • General goals • Capital preservation • Capital appreciation • Income

15. Investment Constraints • Liquidity needs • Varies between investors depending upon age, employment, tax status, etc. • Time horizon • Influences liquidity needs and risk tolerance

16. 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

17. Legal and Regulatory Factors • Limitations or penalties on withdrawals (such as from an RRSP) • Fiduciary responsibilities - “prudent person” rule • Investment laws prohibit insider trading

18. 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

19. 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

20. The Importance of Asset Allocation • According to research by Brinson, Hood & Beebower (1986); Brinson, Singer & Beebower (1991) and Ibbotson & Kaplan (2000) most (85% to 95%) of the overall investment return is due to: • The choice of asset class • The weights allocated to each asset class

21. 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, taxes & expenses have a major impact on realized returns • Returns on Treasury Bills have barely kept pace with inflation

22. 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

23. 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, a larger allocation to equity will improve results • Risk of a strategy depends on the investor’s goals and time horizon

24. 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

25. Asset Allocation Source: Benefits Canada http://www.benefitscanada.com/news/article.jsp?content=20060719_114220_4968

26. Summary • Identify investment needs, risk tolerance, and familiarity with capital markets • Identify objectives and constraints • Enhance investment plans by accurate formulation of an investment policy statement • Focus on asset allocation as it largely determines long-term returns and risk