Investment Analysis and Portfolio Management Eighth Edition by Frank K
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1 Investment Analysis and Portfolio Management Eighth Edition by Frank K Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. BrownChapter 2
2 Chapter 2 The 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 2 The 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 InsuranceLife insuranceTerm life insurance - Provides death benefit only. Premium will change every renewal periodUniversal and variable life insurance – provide cash value plus death benefit
5 Financial Plan Preliminaries InsuranceHealth insuranceDisability insuranceAutomobile insuranceHome/rental insuranceLiability insurance
6 Financial Plan Preliminaries Cash reserveTo meet emergency needsIncludes cash equivalents (liquid investments)Recommendation: Equal to six months living expenses
7 Individual Investor Life Cycle Three phases to an Investor’s life cycle:Accumulation phase – early to middle years of working careerConsolidation phase – past midpoint of career. Earnings greater than expensesSpending/Gifting phase – begins after retirementDesires & constraints will change as one moves through the different stagesAnalyzing data from a 2004 national survey on the first wave of baby boomers, Lusardi and Mitchell found that those who did "a lot" of retirement preparation had a median net worth of $200,000, compared with $84,000 for those who did the least.Source:
10 The Portfolio Management Process Exhibit 2.3The Portfolio Management Process1. Investment Policy statement - Focus: Investor’s short-term and long-term needs, familiarity with capital market history, and expectations2. Examine current and projected financial, economic, political, and social conditions - Focus: Short-term and intermediate-term expected conditions to use in constructing a specific portfolio3. Implement the plan by constructing the portfolio - Focus: Meet the investor’s needs with the minimum amount of risk4. 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 constraintsSets standards for evaluating portfolio performanceReduces 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?
15 Investment Constraints Liquidity needsVaries between investors depending upon age, employment, tax status, etc.Time horizonInfluences liquidity needs and risk tolerance
16 Investment Constraints Tax concernsCapital gains or losses – taxed differently from incomeUnrealized capital gain – reflect price appreciation of currently held assets that have not yet been soldRealized capital gain – when the asset has been sold at a profitTrade-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” ruleInvestment laws prohibit insider trading
18 Unique Needs and Preferences Personal preferences such as socially conscious investments could influence investment choiceTime constraints or lack of expertise for managing the portfolio may require professional managementLarge investment in employer’s stock may require consideration of diversification needs
19 The Importance of Asset Allocation An investment strategy is based on four decisionsWhat asset classes to consider for investmentWhat normal or policy weights to assign to each eligible classDetermining the allowable allocation ranges based on policy weightsWhat 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 classThe 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 tooInflation, taxes & expenses have a major impact on realized returnsReturns 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 returnsFocusing 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 portfolioAsset allocation determines portfolio return more than stock selectionOver long time periods, a larger allocation to equity will improve resultsRisk 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 decisionEquity allocations of U.S. pension funds average 58%In the United Kingdom, equities make up 78% of assetsIn Germany, equity allocation averages 8%In Japan, equities are 37% of assets
26 SummaryIdentify investment needs, risk tolerance, and familiarity with capital marketsIdentify objectives and constraintsEnhance investment plans by accurate formulation of an investment policy statementFocus on asset allocation as it largely determines long-term returns and risk