The Asset Allocation Decision
•Individual Investor Life Cycle
•The Portfolio Management Process
•The Need for Policy Statement
•Constructing the Policy Statement
•The Importance of Asset Allocation
2-1
What is Asset Allocation?
• Asset Allocation
• process of deciding how to distribute an
investor’s wealth among different
countries and asset classes for
investment purposes
• Asset Class
• group of securities that have similar
characteristics, attributes, and
risk/return relationships
2-2
What is Asset Allocation?
•Investor:
• Depending on the type of investors,
investment objectives and
constraints vary
• Individual investors
• Institutional investors
2-3
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
2-4
Individual Investor Life Cycle
Net Worth
Accumulation Consolidation Phase Spending Phase
Phase Gifting Phase
Long-term:
Long-term: Retirement Long-term:
Retirement Estate Planning
Short-term:
Children’s college
Short-term:
Vacations
Short-term: Lifestyle Needs
House Children’s College 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
2-6
Portfolio Management Process:
Policy Statement
• Specifies investment goals and acceptable risk
levels
• Should be reviewed periodically
• Guides all investment decisions
2-7
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
Need for Policy Statement
• Understand investor’s needs and articulate realistic
investment objectives and constraints
• What are the real risks of an adverse financial
outcome, and what emotional reactions will I have?
• How knowledgeable am I about investments and the
financial markets?
• 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 affect me?
• How would any unanticipated portfolio value change
might affect my investment policy?
2-9
Need for a Policy Statement
• Sets standards for evaluating portfolio performance
• Provides a comparison standard in judging the
performance of the portfolio manager
• Benchmark portfolio or comparison standard is used
to reflect the risk and return objectives specified in the
policy statement
• Should act as a starting point for periodic portfolio
review and client communication with the manager
2-10
Need for a Policy Statement
• Other Benefits
• Reduces possibility of inappropriate or unethical
behaviour of the portfolio manager
• Helps create seamless transition from one money
manager to another without costly delays
• Provides the framework to help resolve any
potential disagreements between the client and
the manager
2-11
Input to the Policy Statement
• Constructing the policy statement begins with a
profile analysis of the investor’s current and future
financial situations and a discussion of investment
objectives and constraints.
2-12
Input to the Policy Statement
• Objectives
• Risk
• Return
• Constraints
• Liquidity, time horizon, tax factors, legal and
regulatory constraints, and unique needs and
preferences
2-13
Investment Objectives
• Risk Objectives
• Should be based on investor’s ability to take risk
and willingness to take risk
2-14
Investment Objectives
• Risk tolerance depends on an investor’s current
net worth, income expectations and age
• More net worth allows more risk taking
• Younger people can take more risk
• Careful analysis of client’s risk tolerance should
precede any discussion of return objectives
2-15
Investment Objectives
• Return Objectives
• May be stated in terms of an absolute or a
relative percentage return
• Capital Preservation:
• Minimize risk of real losses
2-16
Investment Objectives
• Capital Appreciation: Growth of the portfolio in
real terms to meet future needs
• Current Income: Focus is in generating income
rather than capital gains
• Total Return: Increase portfolio value by capital
gains and by reinvesting current income with
moderate risk exposure.
2-17
Investment Constraints
• Liquidity
• Vary between investors depending upon age,
employment, tax status, etc.
• Planned vacation expenses and house down
payment are some of the liquidity needs.
2-18
Investment Constraints
• Time
• Influences liquidity needs and risk tolerance
• Longer investment horizons generally requires
less liquidity and more risk tolerance
• Two general time horizons are pre-retirement
and post-retirement periods
2-19
Investment Constraints:
Taxes and Interest Income
• Interest Income: 100% of all interest income is taxed at
an investor’s marginal tax rate.
• Assuming a marginal tax rate of 26%, an investor that
receives Kshs2,000 in interest income will have a Kshs520
tax liability (Kshs2,000 X 26%).
After Tax Return on Investment (AT -ROI)
AT - ROI = Pre-tax ROI X ( 1 – Marginal Tax Rate)
2-20
Investment Constraints:
Taxes and Interest Income
• So if the investor who received ksh2,000 interest
income had made a Ksh100,000 investment, that
would be a 2% ROI on a pre-tax basis. So that, the
after-tax return on investment would be;
After Tax Return on Investment (AT -ROI)
AT – ROI = Pre-Tax ROI X ( 1 – Marginal Tax Rate)
AT - ROI = 2% X ( 1 – .26 ) = 1.48%
2-21
Investment Constraints
• Taxes
• Unrealized capital gains: Reflect price appreciation
of currently held assets that have not yet been sold
• Realized capital gains: When the asset has been sold
at a profit
• Trade-off between taxes and diversification: Tax
consequences of selling company stock for
diversification purposes
2-22
Tax Free Investments
• Earn income that is NOT subject to income taxes
• Tax Free Savings Accounts (TSFA)
2-23
Tax Deferred Investments
• Tax deferred investments
• compound tax free but when withdrawn are subject
to taxes
• Registered Retirement Savings Accounts (RRSP)
• individuals can deposit money into and earn tax
deferred income
• At withdrawal, all funds are subject to tax
2-24
Legal and Regulatory
Constraints
• Limitations or penalties on withdrawals
• Fiduciary responsibilities
• The “Prudent Investor Rule” normally apply
• Investment laws prohibit insider trading
2-25
Legal and Regulatory
Constraints
• Institutional investors deserve special attentions
since legal and regulatory factors may affect them
quite differently
• Example: banks vs. endowment funds
2-26
Personal Constraints:
Unique Needs & 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
2-27
Personal Constraints:
Unique Needs & Preferences
• Large investment in employer’s stock may require
consideration of diversification needs
• Institutional investor’s needs
2-28
Importance of Asset
Allocation
• Asset Allocation:
• process of deciding how to distribute an
investor’s wealth among different countries and
asset classes for investment purposes
2-29
Importance of Asset
Allocation
• An investment strategy is based on four decisions
• What asset classes to consider for investment
• What policy weights to assign to each eligible
class
• What allocation ranges are allowed based on
policy weights
• What specific securities to purchase for the
portfolio
2-30
Importance of Asset Allocation
Historically, small company stocks have generated the
highest returns, so is the volatility
Inflation and taxes have a major impact on returns
Returns on Treasury Bills have barely kept pace with
inflation.
2-31
Contd..,
• 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.
