Chapter 2 The Asset Allocation Decision Zhiqiang Wang School of Finance Dongbei University of Finance & Economics Chapter 2 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 Chapter 2 The Asset Allocation Decision

1. Individual Investor Life Cycle The Preliminaries Life Cycle Net Worth and Investment Strategies Life Cycle Investment Goals Chapter 2 The Asset Allocation Decision

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 Chapter 2 The Asset Allocation Decision

Chapter 2 The Asset Allocation Decision The Preliminaries Insurance Cash reserve Chapter 2 The Asset Allocation Decision

Chapter 2 The Asset Allocation Decision 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 Chapter 2 The Asset Allocation Decision

Chapter 2 The Asset Allocation Decision Cash reserve To meet emergency needs Includes cash equivalents (liquid investments) Equal to six months living expenses recommended by experts Chapter 2 The Asset Allocation Decision

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 Chapter 2 The Asset Allocation Decision

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. Chapter 2 The Asset Allocation Decision

Individual Investor Life Cycle Net Worth Exhibit 2.1 Accumulation Phase Long-term: Retirement Children’s college Short-term: House Car Consolidation Phase Long-term: Retirement Short-term: Vacations Children’s College Spending Phase Gifting Phase Long-term: Estate Planning Short-term: Lifestyle Needs Gifts Age Chapter 2 The Asset Allocation Decision

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 Chapter 2 The Asset Allocation Decision

2. 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 Chapter 2 The Asset Allocation Decision

The Portfolio Management Process Exhibit 2.2 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 Chapter 2 The Asset Allocation Decision

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 Chapter 2 The Asset Allocation Decision

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 Chapter 2 The Asset Allocation Decision

3. The need for a policy statement Understand and Articulate Investor Goals Standards for Evaluating Portfolio Performance Other Benefits Chapter 2 The Asset Allocation Decision

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 Chapter 2 The Asset Allocation Decision

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 Chapter 2 The Asset Allocation Decision

Chapter 2 The Asset Allocation Decision 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 Chapter 2 The Asset Allocation Decision

4. Input to the Policy Statement Investment Objectives Investment Constraints Constructing the Policy Statement Chapter 2 The Asset Allocation Decision

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 Chapter 2 The Asset Allocation Decision

Chapter 2 The Asset Allocation Decision 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 Chapter 2 The Asset Allocation Decision

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. Chapter 2 The Asset Allocation Decision

Chapter 2 The Asset Allocation Decision 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 Chapter 2 The Asset Allocation Decision

Equivalent Taxable Yield For example If an investor is in the 28% marginal tax bracket, a taxable yield of 8% has an after-tax yield of 8%(1-28%)=5.76%; an equivalent-risk municipal security offering a yield greater than 5.76% offers the investor greater after-tax returns. A municipal bond yielding 6% has an equivalent taxable yield of 8.33%= 6%/(1-28%). Chapter 2 The Asset Allocation Decision

Effect of Tax Deferral on Investor Wealth over Time Exhibit 2.4 Investment Value $10,062.66 $5,365.91 $1,000 Time Chapter 2 The Asset Allocation Decision

Methods of Tax Deferral Regular IRA - tax deductible Tax on returns deferred until withdrawal Roth IRA - not tax deductible Tax-free withdrawals possible Cash value life insurance Funds accumulate tax-free until they are withdrawn Tax Sheltered Annuities Employer’s 401(k) and 403(b) plans Tax-deferred investments Chapter 2 The Asset Allocation Decision

Legal and Regulatory Factors Limitations or penalties on withdrawals Fiduciary responsibilities - “prudent man” rule Investment laws prohibit insider trading Chapter 2 The Asset Allocation Decision

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 Institutional investors needs Chapter 2 The Asset Allocation Decision

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 the importance of diversification Chapter 2 The Asset Allocation Decision

Constructing A Policy Statement Questions to be answered: What are the real risks of an adverse financial outcome, especially in the short run? What probable emotional reactions will I have to an adverse financial outcome? 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 may affect my investment needs? What, if any, unanticipated consequences of interim fluctuations in portfolio value might affect my investment policy? Chapter 2 The Asset Allocation Decision

5. The Importance of Asset Allocation Real Investment Returns after Taxes and Costs Returns and Risks of Different Asset Classes Chapter 2 The Asset Allocation Decision

Real Returns and Investment Strategies 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 According to research studies, most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments See Exhibit 2.5 on page 35 Chapter 2 The Asset Allocation Decision

Real Investment Returns after Taxes and Costs For taxable investments, the only way to maintain purchasing power over time when investing in financial assets is to invest in common stock. Compound Annual Returns: 1926-2001 Before taxes and inflation After taxes After taxes and inflation Common Stocks 10.7% 7.9% 4.7% Long-Term Govt. Bonds 5.3% 3.7% 0.6% Treasury Bills 3.8% 2.7% -0.4% Municipal Bond (est.) 6.0% 2.9% Chapter 2 The Asset Allocation Decision

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. See Exhibit 2.7 on page 38. Inflation and taxes have a major impact on returns Returns on Treasury Bills have barely kept pace with inflation. See Exhibit 2.8 on page 39 and 2.9 on page 40. 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 Chapter 2 The Asset Allocation Decision

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 Chapter 2 The Asset Allocation Decision

6. Asset Allocation and Cultural Differences Although non-US investors make their asset allocation decisions in much the same manner, their allocation decisions will be different from those of US investors because they face different social, economic, political, and tax environments. National difference in environment can explain much of the divergent portfolio strategies Chapter 2 The Asset Allocation Decision

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 Chapter 2 The Asset Allocation Decision

Chapter 2 The Asset Allocation Decision Summary Identify investment needs, risk tolerance, and familiarity with capital markets Identify objectives and constraints Enhance investment plans by accurate formulation of a policy statement Focus on asset allocation as it determines long-term returns and risk Chapter 2 The Asset Allocation Decision