Chapter 05

Chapter 5Chapter 5

INVESTMENT POLICY INVESTMENT POLICY STATEMENTS AND ASSET STATEMENTS AND ASSET

ALLOCATION ISSUESALLOCATION ISSUES

Chapter 5 QuestionsChapter 5 Questions

•• What is asset allocation?What is asset allocation?•• What are four basic risk management What are four basic risk management

strategies?strategies?•• How and why do investment goals How and why do investment goals

change over a personchange over a person’’s lifetime and s lifetime and circumstances?circumstances?

•• What are the four steps in the portfolio What are the four steps in the portfolio management process?management process?

Chapter 5 QuestionsChapter 5 Questions

•• Why is a policy statement important to the Why is a policy statement important to the planning process?planning process?

•• What objectives and constraints should be What objectives and constraints should be detailed in the policy statement?detailed in the policy statement?

•• Why is investment education necessary?Why is investment education necessary?•• What is the role of asset allocation in What is the role of asset allocation in

investment planning?investment planning?•• Why do asset allocation strategies differ Why do asset allocation strategies differ

across national boundaries?across national boundaries?

What is asset allocation?What is asset allocation?

•• The process of deciding The process of deciding how to distribute wealth how to distribute wealth among asset classes, among asset classes, sectors, and countries sectors, and countries for investment for investment purposes.purposes.

•• Not an isolated choice, Not an isolated choice, but rather a component but rather a component of the portfolio of the portfolio management process.management process.

Managing RiskManaging Risk

Since risk drives Since risk drives expected return, expected return, investing involves investing involves managing risk rather managing risk rather than managing than managing return.return.

Risk Management StrategiesRisk Management Strategies

•• Risk AvoidanceRisk Avoidance–– Can avoid any real chances of lossCan avoid any real chances of loss–– Generally a poor strategy except for a part Generally a poor strategy except for a part

of an overall portfolioof an overall portfolio•• Risk AnticipationRisk Anticipation

–– Position part of your portfolio to protect Position part of your portfolio to protect against anticipated risk factorsagainst anticipated risk factors

–– For example, maintain a cash reserveFor example, maintain a cash reserve

Risk Management StrategiesRisk Management Strategies

•• Risk TransferRisk Transfer–– Insurance and other investment vehicles can Insurance and other investment vehicles can

allow for the transfer of risk, often at a price, to allow for the transfer of risk, often at a price, to another investor who is willing to bear the riskanother investor who is willing to bear the risk

•• Risk ReductionRisk Reduction–– Effective diversification and asset allocation Effective diversification and asset allocation

strategies can reduce risk, sometimes without strategies can reduce risk, sometimes without sacrificing expected return. sacrificing expected return.

Individual Investor Life CycleIndividual Investor Life Cycle

The individual investors life cycle can The individual investors life cycle can often be described using four separate often be described using four separate phases or stages:phases or stages:

•• Accumulation PhaseAccumulation Phase•• Consolidation PhaseConsolidation Phase•• Spending PhaseSpending Phase•• Gifting PhaseGifting Phase

Accumulation PhaseAccumulation Phase

•• Early to middle years of careersEarly to middle years of careers•• Attempting to satisfy intermediate and longAttempting to satisfy intermediate and long--

term goalsterm goals•• Net worth is usually small, debt may be Net worth is usually small, debt may be

heavyheavy•• LongLong--term investment horizon means usually term investment horizon means usually

willing to take moderately high risks in order willing to take moderately high risks in order to make aboveto make above--average returnsaverage returns

Consolidation PhaseConsolidation Phase

•• Past career midpointPast career midpoint•• Have paid off much of their Have paid off much of their

accumulated debtaccumulated debt•• Earnings now exceed living expenses, Earnings now exceed living expenses,

so the balance can be investedso the balance can be invested•• Time horizon is still longTime horizon is still long--term, so term, so

moderately high risk investments are moderately high risk investments are still attractivestill attractive

Spending PhaseSpending Phase

•• Usually begins at retirementUsually begins at retirement•• Saving before, prudent spending nowSaving before, prudent spending now•• Living expenses covered by Social Living expenses covered by Social

Security and retirement plansSecurity and retirement plans•• Changing emphasis toward Changing emphasis toward

preservation of capital, but still want preservation of capital, but still want investment values to keep pace with investment values to keep pace with inflationinflation

Gifting PhaseGifting Phase

•• Can be concurrent with spending phaseCan be concurrent with spending phase•• If resources allow, individuals can now If resources allow, individuals can now

use excess assets to provide gifts to use excess assets to provide gifts to other individuals or organizationsother individuals or organizations

•• Estate planning becomes important, Estate planning becomes important, especially tax considerationsespecially tax considerations

The Portfolio Management The Portfolio Management ProcessProcess

A four step process:A four step process:1.1. Construct a policy statementConstruct a policy statement2.2. Study current financial conditions and Study current financial conditions and

forecast future trendsforecast future trends3.3. Construct a portfolioConstruct a portfolio4.4. Monitor needs and conditionsMonitor needs and conditions


1. Policy statement1. Policy statement–– Specifies investment goals and acceptable Specifies investment goals and acceptable

risk levelsrisk levels–– The The ““road maproad map”” that guides all investment that guides all investment

decisionsdecisions


2. Study current financial and economic 2. Study current financial and economic conditions and forecast future trendsconditions and forecast future trends–– Determine strategies that should meet Determine strategies that should meet

goals within the expected environmentgoals within the expected environment–– Requires monitoring and updates since Requires monitoring and updates since

financial markets are everfinancial markets are ever--changingchanging


3. Construct the portfolio3. Construct the portfolio–– Given the policy statement and the Given the policy statement and the

expected conditions, go about investingexpected conditions, go about investing–– Allocate available funds to meet goals Allocate available funds to meet goals

while managing riskwhile managing risk


4. Monitor and update4. Monitor and update–– Revise policy statement as neededRevise policy statement as needed–– Monitor changing financial and economic Monitor changing financial and economic

conditionsconditions–– Evaluate portfolio performanceEvaluate portfolio performance–– Modify portfolio investments accordinglyModify portfolio investments accordingly

The Policy StatementThe Policy Statement

•• Understand and articulate realistic goalsUnderstand and articulate realistic goals–– Know yourselfKnow yourself–– Know the risks and potential rewards from Know the risks and potential rewards from

investmentsinvestments

•• Learn about standards for evaluating portfolio Learn about standards for evaluating portfolio performanceperformance–– Know how to judge average performanceKnow how to judge average performance–– Adjust for riskAdjust for risk

The Policy StatementThe Policy Statement

•• DonDon’’t try to navigate t try to navigate without a map!without a map!

•• Important Inputs:Important Inputs:–– Investment Investment

Objectives Objectives –– Investment Investment

ConstraintsConstraints

Investment ObjectivesInvestment Objectives

Need to specify return Need to specify return and risk objectivesand risk objectives–– Need to consider the Need to consider the

risk tolerance of the risk tolerance of the investorinvestor

–– Return goals need to Return goals need to be consistent with be consistent with risk tolerancerisk tolerance

–– These will change These will change over timeover time


Possible broad goals:Possible broad goals:•• Capital preservationCapital preservation

–– Maintain purchasing powerMaintain purchasing power–– Minimize the risk of lossMinimize the risk of loss

•• Capital appreciationCapital appreciation–– Achieve portfolio growth through capital Achieve portfolio growth through capital

gainsgains–– Accept greater riskAccept greater risk


•• Current incomeCurrent income–– Look to generate income rather than capital gainsLook to generate income rather than capital gains–– May be preferred in May be preferred in ““spending phasespending phase””–– Relatively low risk Relatively low risk

•• Total returnTotal return–– Combining income returns and reinvestment with Combining income returns and reinvestment with

capital gainscapital gains–– Moderate riskModerate risk

Investment ConstraintsInvestment Constraints

These factors may limit or at least impact the These factors may limit or at least impact the investment choices:investment choices:

•• Liquidity needsLiquidity needs–– How soon will the money be needed?How soon will the money be needed?

•• Time horizonTime horizon–– How able is the investor to ride out several bad How able is the investor to ride out several bad

years?years?•• Legal and Regulatory FactorsLegal and Regulatory Factors

–– Legal restrictions often constrain decisionsLegal restrictions often constrain decisions–– Retirement regulationsRetirement regulations

Investment ConstraintsInvestment Constraints

•• Tax ConcernsTax Concerns–– Realized capital gains vs. Ordinary income?Realized capital gains vs. Ordinary income?–– Taxable vs. TaxTaxable vs. Tax--exempt bonds?exempt bonds?–– Regular IRA vs. Roth IRA?Regular IRA vs. Roth IRA?–– 401(k) and 403(b) plans401(k) and 403(b) plans

•• Unique needs and preferencesUnique needs and preferences–– Perhaps the investor wishes to avoid types of Perhaps the investor wishes to avoid types of

investments for ethical reasonsinvestments for ethical reasons

Investment EducationInvestment Education

•• The type of information necessary to The type of information necessary to construct a good policy statement is neither construct a good policy statement is neither ““common sensecommon sense”” or or ““common knowledge.common knowledge.””

•• Many investors fail to diversify.Many investors fail to diversify.•• Many fail to plan completely.Many fail to plan completely.•• Data indicates that many Americans have Data indicates that many Americans have

greatly undergreatly under--invested for the future.invested for the future.•• The bottom line: If you do not plan for the The bottom line: If you do not plan for the

future, you will likely not be prepared for it.future, you will likely not be prepared for it.

Asset Allocation DecisionsAsset Allocation Decisions

Four decisions in an investment strategy:Four decisions in an investment strategy:•• What asset classes should be considered?What asset classes should be considered?•• What should be the normal weight for each What should be the normal weight for each

asset class?asset class?•• What are the allowable ranges for the What are the allowable ranges for the

weights?weights?•• What specific securities should be What specific securities should be

purchased?purchased?

The Importance of Asset The Importance of Asset AllocationAllocation

•• The asset allocation decision (which classes The asset allocation decision (which classes and at what weights) is very important. Using and at what weights) is very important. Using fund data:fund data:–– About 90% of return variability over time can be About 90% of return variability over time can be

explained by asset allocation.explained by asset allocation.–– About 40% of the differences between returns can About 40% of the differences between returns can

be explained by differences in asset allocation.be explained by differences in asset allocation.

•• Asset allocation is thus the major factor that Asset allocation is thus the major factor that drives portfolio risk and return.drives portfolio risk and return.

Risk/Return History and Risk/Return History and Asset AllocationAsset Allocation

Looking at return data on various asset classes Looking at return data on various asset classes indicate some important factors for investors:indicate some important factors for investors:–– Over long time horizons, stocks have always Over long time horizons, stocks have always

outperformed lowoutperformed low--risk investments.risk investments.–– So the additional risk of stock investing (higher So the additional risk of stock investing (higher

return standard deviations) over shorter time return standard deviations) over shorter time horizons seems to all but disappear over time.horizons seems to all but disappear over time.

–– Need to consider real investment returns over Need to consider real investment returns over taxes and coststaxes and costs

Asset Allocation and Cultural Asset Allocation and Cultural DifferencesDifferences

•• Differences in social, political, and tax Differences in social, political, and tax environments influence asset allocation.environments influence asset allocation.

•• For instance, 58% of pension fund assets are For instance, 58% of pension fund assets are invested in equities in the U.S.invested in equities in the U.S.–– 78% in equities in United Kingdom, where high 78% in equities in United Kingdom, where high

average inflation impacts this choiceaverage inflation impacts this choice–– 8% in equities in Germany, where generous 8% in equities in Germany, where generous

government pensions and greater risk aversion government pensions and greater risk aversion seem to play a strong roleseem to play a strong role

Chapter 05

Economy & Finance

transfer of risk

risk tolerance

moderate risk

greater risk

returnand risk objectives

anticipated risk factors

low risk total return

portfolio investments