1. The Asset Allocation Decision
Chapter 2
The Asset Allocation Decision

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

3. The Portfolio Management Process
Exhibit 2.2
1. Policy statement (road map)- Focus: Investor’s short-term and long-term needs, familiarity with capital market history, and expectations
2. Examine current and projected 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

4. 投資決策過程
來源:徐俊明, 投資學理論與實務, 4版

5. Input to the policy statement
Investment objectives expressed in terms of risk and return:
Risk Tolerance
Psychological makeup
Insurance coverage
Cash reserves
Family situation
Age
Current net worth
Income expectations

6. Investment objectives expressed in terms of risk and return:
Return objective
Absolute or relative percentage return
General goals

7. General Goals Capital preservation Capital appreciation
minimize risk of real loss
Capital appreciation
Growth of the portfolio in real terms to meet future need

8. General Goals Total return Income generation
Increase portfolio value by capital gains and by reinvesting current income
Maintain moderate risk exposure
Income generation
Focus is in generating income rather than capital gains

9. Risk Categories and Suggested Asset Allocations for Merrill Lynch Clients
Exhibit 2.3

10. Risk Categories and Suggested Asset Allocations for Merrill Lynch Clients
Exhibit 2.3

11. How Much Risk is Right for You?
Exhibit 2.4

12. Investment Constraints
Liquidity needs
Vary between investors depending upon age, employment, tax status, etc.
Time horizon
Influences liquidity needs and risk tolerance (longer time horizon faces less liquidity and larger risk)

13. Investment Constraints
Tax concerns
Capital gains/losses or income distributions?
Unrealized vs realized capital gain
Trade-off between taxes and diversification (use employee payroll deduction plans or 401k to buy company stocks)

14. Investment Constraints
Tax concerns (continued)
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

15. Equivalent Taxable Yield

16. Effect of Tax Deferral on Investor Wealth over Time
Exhibit 2.6
Investment Value
$10,062.66
$5,365.91
$1,000
Time
Marginal tax=28%, after-tax return=5.76%=8%× (1-28%)

17. Methods of Tax Deferral (for US)
Regular IRA – contributions tax deductible
Tax on returns deferred until withdrawal
Roth IRA – contributions not tax deductible
tax-free on returns 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

18. Historical Average Annual Returns and Return Variability, 1926-2001
Exhibit 2.9

19. Over Long Time Periods, Equities Offer Higher Returns
Exhibit 2.10

20. Returns and Risk of Different Asset Classes
Historically, small company stocks have generated the higher returns. But the volatility of returns have been higher too.
Inflation and taxes have a major impact on returns.
Returns on Treasury Bills have barely kept pace with inflation.

21. Extra reading:
Appendix of Chapter 2: Objectives and Constraints of Institutional Investors (pages 63-66)
Mutual Funds
Pension funds
Endowment funds
Insurance companies
Banks