INVESTMENT POLICY STATEMENTS AND ASSET ALLOCATION ISSUES
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1 INVESTMENT POLICY STATEMENTS AND ASSET ALLOCATION ISSUES Chapter 4INVESTMENT POLICY STATEMENTS AND ASSET ALLOCATION ISSUES
2 Chapter 4 Questions What is asset allocation? What are four basic risk management strategies?How and why do investment goals change over a person’s lifetime and circumstances?What are the four steps in the portfolio management process?
3 What is asset allocation? The process of deciding how to distribute wealth among asset classes, sectors, and countries for investment purposes.Not an isolated choice, but rather a component of the portfolio management process.
4 Managing RiskSince risk drives expected return, investing involves managing risk rather than managing return.
5 Risk Management Strategies Risk AvoidanceCan avoid any real chances of lossGenerally a poor strategy except for a part of an overall portfolioRisk AnticipationPosition part of your portfolio to protect against anticipated risk factorsFor example, maintain a cash reserve
6 Risk Management Strategies Risk TransferInsurance and other investment vehicles can allow for the transfer of risk, often at a price, to another investor who is willing to bear the riskRisk ReductionEffective diversification and asset allocation strategies can reduce risk, sometimes without sacrificing expected return.
7 Individual Investor Life Cycle The individual investors life cycle can often be described using four separate phases or stages:Accumulation PhaseConsolidation PhaseSpending PhaseGifting Phase
8 Accumulation Phase Early to middle years of careers Attempting to satisfy intermediate and long-term goalsNet worth is usually small, debt may be heavyLong-term investment horizon means usually willing to take moderately high risks in order to make above-average returns
9 Consolidation Phase Past career midpoint Have paid off much of their accumulated debtEarnings now exceed living expenses, so the balance can be investedTime horizon is still long-term, so moderately high risk investments are still attractive
10 Spending Phase Usually begins at retirement Saving before, prudent spending nowLiving expenses covered by Social Security and retirement plansChanging emphasis toward preservation of capital, but still want investment values to keep pace with inflation
11 Gifting Phase Can be concurrent with spending phase If resources allow, individuals can now use excess assets to provide gifts to other individuals or organizationsEstate planning becomes important, especially tax considerations
12 The Portfolio Management Process A four step process:Construct a policy statementStudy current financial conditions and forecast future trendsConstruct a portfolioMonitor needs and conditions
13 The Portfolio Management Process 1. Policy statementSpecifies investment goals and acceptable risk levelsThe “road map” that guides all investment decisions
14 The Portfolio Management Process 2. Study current financial and economic conditions and forecast future trendsDetermine strategies that should meet goals within the expected environmentRequires monitoring and updates since financial markets are ever-changing
15 The Portfolio Management Process 3. Construct the portfolioGiven the policy statement and the expected conditions, go about investingAllocate available funds to meet goals while managing risk
16 The Portfolio Management Process 4. Monitor and updateRevise policy statement as neededMonitor changing financial and economic conditionsEvaluate portfolio performanceModify portfolio investments accordingly
17 The Policy Statement Understand and articulate realistic goals Know yourselfKnow the risks and potential rewards from investmentsLearn about standards for evaluating portfolio performanceKnow how to judge average performanceAdjust for risk
18 The Policy Statement Don’t try to navigate without a map! Important Inputs:Investment ObjectivesInvestment Constraints
19 Investment Objectives Need to specify return and risk objectivesNeed to consider the risk tolerance of the investorReturn goals need to be consistent with risk toleranceThese will change over time
20 Investment Objectives Possible broad goals:Capital preservationMaintain purchasing powerMinimize the risk of lossCapital appreciationAchieve portfolio growth through capital gainsAccept greater risk
21 Investment Objectives Current incomeLook to generate income rather than capital gainsMay be preferred in “spending phase”Relatively low riskTotal returnCombining income returns and reinvestment with capital gainsModerate risk
22 Investment Constraints These factors may limit or at least impact the investment choices:Liquidity needsHow soon will the money be needed?Time horizonHow able is the investor to ride out several bad years?Legal and Regulatory FactorsLegal restrictions often constrain decisionsRetirement regulations
23 Investment Constraints Tax ConcernsRealized capital gains vs. Ordinary income?Taxable vs. Tax-exempt bonds?Regular IRA vs. Roth IRA?401(k) and 403(b) plansUnique needs and preferencesPerhaps the investor wishes to avoid types of investments for ethical reasons
24 Asset Allocation Decisions Four decisions in an investment strategy:What asset classes should be considered?What should be the normal weight for each asset class?What are the allowable ranges for the weights?What specific securities should be purchased?
25 The Importance of Asset Allocation The asset allocation decision (which classes and at what weights) is very important. Using fund data:About 90% of return variability over time can be explained by asset allocation.About 40% of the differences between returns can be explained by differences in asset allocation.Asset allocation is thus the major factor that drives portfolio risk and return.
26 Risk/Return History and Asset Allocation Looking at return data on various asset classes indicate some important factors for investors:Over long time horizons, stocks have always outperformed low-risk investments.So the additional risk of stock investing (higher return standard deviations) over shorter time horizons seems to all but disappear over time.Need to consider real investment returns over taxes and costs
27 Asset Allocation and Cultural Differences Differences in social, political, and tax environments influence asset allocation.For instance, 58% of pension fund assets are invested in equities in the U.S.78% in equities in United Kingdom, where high average inflation impacts this choice8% in equities in Germany, where generous government pensions and greater risk aversion seem to play a strong role