THE ASSET
ALLOCATION
DECISION
THE ASSET ALLOCATION DECISION
• 1. Individual Investor Life Cycle
• 2. The Portfolio Management Process
• 3. The Need for a Policy Statement
• 4. Input to the Policy Statement
• 5. The Importance of Asset Allocation
• 6. Asset Allocation and Cultural Differences
1. INDIVIDUAL INVESTOR LIFE CYCLE
• The Preliminaries
• Life Cycle Net Worth and Investment Strategies
• Life Cycle Investment Goals
INDIVIDUAL INVESTOR LIFE CYCLE
• Investment needs change over a person’s life cycle.
• How individuals structure their financial plans should be
related to their age, financial status, future plans, and
needs
• Pre-investment needs: insurance and cash reserve
• Life cycle investment strategies
• Life cycle investment goals
THE PRELIMINARIES
• Insurance
• Cash reserve
INSURANCE
• Life insurance
• Term life insurance - Provides death benefit only. Premium could change
every renewal period
• Universal and variable life insurance – provide cash value plus death benefit
• Health insurance
• Disability insurance
• Automobile insurance
• Home/rental insurance
• Liability insurance
CASH RESERVE
• To meet emergency needs
• Includes cash equivalents (liquid investments)
• Equal to six months living expenses recommended by experts
LIFE CYCLE INVESTMENT STRATEGIES(1)
• Accumulation phase
• In early-to-middle years of their working careers
• Their net worth is small
• Making fairly high-risk and long-term investments
• Consolidation phase
• Past the midpoint of their careers
• Earnings exceed expenses
• Making moderate-risk and long-term investments
LIFE CYCLE INVESTMENT STRATEGIES(2)
• Spending phase/Gifting phase
• Begins after retirement (Individual retire)
• Living expenses are covered by Social Security income and income from
prior investments, including employer pension plans
• Making less-risk investments
• Have sufficient income to cover their expenses
• Provide assistance to relatives and friend, etc.
LIFE CYCLE INVESTMENT GOALS
• Near-term, High-priority goals
• Shorter-term financial objectives, such as a house down payment
• Long-term, High-priority goals
• Typically include the ability to retire at a certain age
• Lower-priority goals
• Not critical, e.g., buying a new car
THE PORTFOLIO MANAGEMENT PROCESS
• Four steps of the portfolio management process
• (1) Policy statement
• (2) Examine current financial, economic, political,and social conditions(
• 3) Implement the plan by constructing the portfolio
• (4) Feedback loop
• As seen Exhibit 2.2 on next slide
THE PORTFOLIO MANAGEMENT PROCESS
(1) Policy statement
• Specifies investment goals and acceptable risk levels
• Should be reviewed periodically
• Guides all investment decisions
(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
• (4) Monitor and update
• Evaluate portfolio performance
• Monitor investor’s needs and market conditions
• Revise policy statement as needed
• Modify investment strategy accordingly
THE NEED FOR A POLICY STATEMENT
• Understand and Articulate Investor Goals
• Standards for Evaluating Portfolio
• Performance
• Other Benefits
UNDERSTAND AND ARTICULATE
INVESTOR GOALS
• Helps investors understand their own needs, objectives, and
investment constraints
• An important purpose of writing a policy statement is to help investors
understand their needs, objectives, and investment constraints
• The policy statement helps the investor to specify realistic goals and
become better informed about the risks and costs of investing
STANDARDS FOR EVALUATING
PORTFOLIO PERFORMANCE
• Sets standards for evaluating portfolio performance
• The policy statement is also the basis for judging the performance of the
portfolio manager
OTHER BENEFITS
• Reduces the possibility of inappropriate behavior on the part of the
portfolio manager
• A sound policy statement helps to protect the client against a portfolio
manager’s inappropriate investments or unethical behavior
4. INPUT TO THE POLICY STATEMENT
• Investment Objectives
• Investment Constraints
• Constructing the Policy Statement
INVESTMENT OBJECTIVES
• Risk Tolerance
• Risk categories and suggested asset allocation for Merrill Lynch clients
• See Exhibit 2.3 on page 29
• Absolute or relative percentage return
• General goals
GENERAL GOALS
• Capital preservation
• Minimize risk of real loss
• Capital appreciation
• Growth of the portfolio in real terms to meet future need
• Current income
• Focus is in generating income rather than capital gains
• Total return
• Increase portfolio value by capital gains and by reinvesting current income
• Maintain moderate risk exposure
INVESTMENT CONSTRAINTS
• Liquidity needs
• Vary between investors depending upon age, employment, tax status, etc.
• Time horizon
• Influences liquidity needs and risk tolerance
• Tax concerns
• Investment planning is complicated by the tax code
• Legal and regulatory factors
• These factors constraint the investment strategies
• Unique needs and preferences
• Personal preferences, the time and expertise, etc.
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
• 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
EQUIVALENT TAXABLE YIELD
