1. 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?

2. 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?

3. Individual Investor Life Cycle
Net Worth
Figure 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

4. The Portfolio Management Process
Figure 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

5. Policy Statement
The Smith Family Portfolio’s primary focus is the production of current income, with long-term capital appreciation a secondary consideration. The need for a dependable income stream precludes investment vehicles with even modest likelihood of losses. Liquidity needs reinforce the need to emphasize minimum-risk investments. Extensive use of short-term investment-grade investments is entirely justified by the expectation that a low-inflation environment will exist indefinitely into the future. For these reasons, investments will emphasize U.S. Treasury bills and notes, intermediate-term investment-grade corporate debt, and select “blue chip” stocks whose dividend distributions are assured and whose price fluctuations are minimal.

6. Standards For Evaluating Portfolio Performance
Benchmark portfolio
risk and return
Matches risk preferences and investment needs
analysis of risk tolerance
return objective goals

7. Realistic Investor Goals
Capital preservation
minimize risk of real loss
strongly risk-averse or funds needed soon
Capital appreciation
capital gains to provide real growth over time for future need
aggressive strategy with accepted risk
Current income
generate spendable funds
Total return
capital gains and income reinvestment
moderate risk exposure

8. Investment Constraints
Liquidity needs
Time horizon
Tax concerns
Interest and dividends
Capital gain/loss
Munis -
Retirement accts (tax deferral)

9. Effect of Tax Deferral on Investor Wealth over Time
Figure 2.5
Investment Value
$10,063
$5,365
$1,000
Time

10. Methods of Tax Deferral
Regular IRA - tax deductible
withdrawals taxable
Roth IRA - not tax deductible
tax-free withdrawals possible
Annuities
Employer’s 401(k) and 403(b) plans

11. The Effect of Taxes and Inflation on Investment Returns, 1926 - 1998
Figure 2.6
Before Taxes
After Taxes
After Taxes and Inflation

12. The Effect of Taxes and Inflation on Returns: 1981-2004

13. Legal and Regulatory Factors
Limitations or penalties on withdrawals
Fiduciary responsibilities - “prudent man” rule
Investment laws prohibit insider trading

14. Unique Needs and Preferences
Personal preferences - socially conscious investments
Time constraints or expertise for managing the portfolio may require professional management
Large investment in employer may require consideration of diversification needs and realistic liquidity
Institutional investors needs

15. The Importance of Asset Allocation
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
The allowable allocation ranges based on policy weights
What specific securities to purchase for the portfolio

16. Returns and Risk of Different Asset Classes
Higher returns compensate for risk
Policy statements must provide risk guidelines
Measuring risk by standard deviation of returns over time indicates stocks are more risky than T-bills

17. Historical Average Annual Returns and Return Variability: 1926-2001

18. 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 risk of T-bills is large because of different expected returns
Focusing only on return variability ignores reinvestment risk
Changes in returns from year to year

19. 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

20. Asset Allocation and Cultural Differences
Social, political, and tax environments
U.S. institutional investors average 45% allocation in equities
In the United Kingdom, equities make up 72% of assets
In Germany, equities are 11%
In Japan, equities are 24% of assets

21. Asset Allocation Strategies
Integrated asset allocation
capital market conditions
investor’s objectives and constraints
Strategic asset allocation
constant-mix
Tactical asset allocation
mean reversion
inherently contrarian
Insured asset allocation
constant proportion

22. Asset Allocation Strategies
Selecting an allocation method depends on:
Perceptions of variability in the client’s objectives and constraints
Perceived relationship between the past and future capital market conditions

23. The Importance of Asset Allocation
Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?
Ibbotson and Kaplan FAJ Jan/Feb 2000

24. Summary Develop an investment policy statement
Identify investment needs, risk tolerance, and familiarity with capital markets
Identify objectives and constraints
Investment plans are enhanced by accurate formulation of a policy statement
Asset allocation determines long-run returns and risk
Success depends on construction of the policy statement

25. Style
Construct a portfolio to capture one or more of the characteristics of equity securities
Small-capitalization stocks, low-P/E stocks, etc…
Value stocks appear to be underpriced
price/book or price/earnings
Growth stocks enjoy above-average earnings per share increases

26. Does Style Matter?
Choice to align with investment style communicates information to clients
Determining style is useful in measuring performance relative to a benchmark
Style identification allows an investor to diversify by portfolio
Style investing allows control of the total portfolio to be shared between the investment managers and a sponsor

27. Determining Style Style grid: Style analysis firm size
value-growth characteristics
Style analysis
constrained least squares

28. Benchmark Portfolios Sharpe
T-bills, intermediate-term government bonds, long-term government bonds, corporate bonds, mortgage related securities, large-capitalization value stocks, large-capitalization growth stocks, medium-capitalization stocks, small-capitalization stocks, non-U.S. bonds, European stocks, and Japanese stocks

29. Benchmark Portfolios Sharpe BARRA
Uses portfolios formed around 13 different security characteristics, including variability in markets, past firm success, firm size, trading activity, growth orientation, earnings-to-price ratio, book-to-price ratio, earnings variability, financial leverage, foreign income, labor intensity, yield, and low capitalization

30. Benchmark Portfolios Sharpe BARRA Ibbotson Associates
simplest style model uses portfolios formed around five different characteristics: cash (T-bills), large-capitalization growth, small-capitalization growth, large-capitalization value, and small-capitalization value

31. Timing Between Styles
Variations in returns among mutual funds are largely attributable to differences in styles
Different styles tend to move at different times in the business cycle

32. Value versus Growth
Growth stocks will outperform value stocks for a time and then the opposite occurs
Over time value stocks have offered somewhat higher returns than growth stocks

33. Value versus Growth Growth-oriented investor will:
focus on EPS and its economic determinants
look for companies expected to have rapid EPS growth
assumes constant P/E ratio

34. Value versus Growth Value-oriented investor will:
focus on the price component
not care much about current earnings
assume the P/E ratio is below its natural level

35. Value and Growth Investing
Value and Growth Investing: Review and Update
Chan and Lakonishok – Financial Analysts Journal Jan/Feb 2004