investment

Investment Analysis and Portfolio Management

Dr. Tahir Khan Durrani

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


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


Risk Driven Returns

• The practice of investing funds and managing portfolios should focus primarily on managing risk rather than on managing returns.

• The practical implications of risk management in the context of asset allocation.

4


Risk Driven Returns• Asset allocation is the process of deciding how

to distribute an investor’s wealth among different countries and asset classes for investment purposes.

• An asset class is comprised of securities that have similar characteristics, attributes, and risk/return relationships.– A broad asset class, such as “bonds,” can be divided

into smaller asset classes, such as Treasury bonds, corporate bonds, and high-yield bonds.

5


Individual Investor’s Life Cycle

• Financial plans and investment needs are as different as each individual. Investment needs change over a person’s life cycle.

• How individuals structure their financial plan should be related to their age, financial status, future plans, risk aversion characteristics, and needs.

• No serious investment plan should be started until a potential investor has adequate income to cover living expenses and has a safety net should the unexpected occur. 6


Individual Investor Life Cycle

• Accumulation phase – early to middle years of working career

• Consolidation phase – past midpoint of careers. Earnings greater than expenses

• Spending/Gifting phase – begins after retirement

7


Financial Plan Preliminaries

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

8



Insurance– Health insurance

– Disability insurance

– Automobile insurance

– Home/rental insurance

– Liability insurance

9



Cash reserve– To meet emergency needs

– Includes cash equivalents (liquid investments)

– Equal to six months living expenses recommended by experts

10


Individual Investor Life Cycle

25 35 45 55 65 75

Net Worth

Age

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

Exhibit 2.1

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Life Cycle Investment Goals• Near-term, high-priority goals

– Shorter-term financial objectives that individuals set to fund purchases that are personally important to them, such as accumulating funds to make a house down payment, buy a new car, or take a trip.

• Long-term, high-priority goals– Include some form of financial independence, such as

the ability to retire at a certain age.

• Lower-priority goals

– It might be nice to meet these objectives, but it is not critical.12


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

Exhibit 2.2

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1. Policy statement– specifies investment goals and

acceptable risk levels

– should be reviewed periodically

– guides all investment decisions

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The Portfolio Management Process 2. Study current financial and

economic conditions and forecast future trends– determine strategies to meet goals

– requires monitoring and updating• Economies are dynamic; they are affected by

numerous industry struggles, politics, and changing demographics and social attitudes. Thus, the portfolio will require constant monitoring and updating to reflect changes in financial market expectations.

15


The Portfolio Management Process 3. Construct the portfolio

– With the help of investor’s policy statement and financial market forecasts as input, the advisors implement the investment strategy

– allocate available funds to minimize investor’s risks and meet investment goals

– determine how to allocate available funds across different countries, asset classes, and securities.

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4. Monitor and update– evaluate portfolio performance– Monitor investor’s needs and market

conditions– revise policy statement as needed– modify investment strategy accordingly

17


The Need For A Policy Statement

• Helps investors understand their own needs, objectives, and investment constraints

• Sets standards for evaluating portfolio performance, after learning about the financial markets and the risks of investing.

• Reduces the possibility of inappropriate behavior on the part of the portfolio manager

18


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?

19


Constructing A Policy Statement• An important purpose of writing a policy statement

is to help investors understand their own needs, objectives, and investment constraints.

• As part of this, investors need to learn about financial markets and the risks of investing.

• This background will help prevent them from making inappropriate investment decisions in the future and will increase the possibility that they will satisfy their specific, measurable financial goals.

20


Constructing A Policy Statement

• 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?

21


Constructing A Policy Statement• Constructing a policy statement is mainly the investor’s

responsibility. • It is a process whereby investors articulate their realistic

needs and goals and become familiar with financial markets and investing risks.

• Without this information, investors cannot adequately communicate their needs to the portfolio manager.

• Without this input from investors, the portfolio manager cannot construct a portfolio that will satisfy clients’ needs.

• The result of bypassing this step will most likely be future aggravation, dissatisfaction, and disappointment.

22


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Investment Objectives

• Risk Tolerance

• Absolute or relative percentage return

• General goals

24


Risk Tolerance• Risk tolerance is affected by factors like;

– a person’s current insurance coverage and cash reserves

– an individual’s family situation– one’s current net worth and income expectations

• All else being equal, individuals with higher incomes have a greater propensity to undertake

• risk because their incomes can help cover any shortfall.

25


Investment Objectives• Capital preservation

– minimize risk of real loss– maintain the purchasing power of their investment

• Capital appreciation– Growth of the portfolio in real terms to meet future need– growth mainly occurs through capital gains

• Current income– Focus is in generating income rather than capital gains– This strategy sometimes suits investors who want to

supplement their earnings with income generated by their portfolio to meet their living expenses.

26


Investment Objectives• Total return

– Increase portfolio value by capital gains and by reinvesting current income

– Maintain moderate risk exposure

– Its risk exposure lies between that of the current income and capital appreciation strategies.

27


Investment Constraints• Liquidity needs

– assets are more liquid if many traders are interested in a fairly standardized product.

– Vary between investors depending upon age, employment, tax status, etc.

• Time horizon– Influences liquidity needs and risk tolerance– Investors with long investment horizons generally require

less liquidity and can tolerate greater portfolio risk: • less liquidity because the funds are not usually needed for many

years; greater risk tolerance because any shortfalls or losses can be overcome by returns earned in subsequent years.

28


Investment Constraints• 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

29


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

30


Return of Taxable Investment• Some sources of income are exempt from federal

and state taxes.

• Interest on federal securities, such as Treasury bills, notes, and bonds, is exempt from state taxes.

• Interest on municipal bonds are exempt from federal taxes.

• Further, if the investor purchases municipal bonds issued by a local governing body of the state in which they live, the interest is usually exempt from both state and federal income tax.

31


Return of Taxable Investment• Thus, high-income individuals have an

incentive to purchase municipal bonds to reduce their tax liabilities.

• The after-tax return on a taxable investment is:

• After-Tax Return = Pre-Tax Return X (1 – Marginal Tax Rate)

32


Equivalent Taxable Yield

• The after-tax return on a taxable investment should be compared to that on municipals before deciding which should be purchased by a tax-paying investor.

• Alternatively, a municipal’s equivalent taxable yield can be computed.

• The equivalent taxable yield is what a taxable bond investment would have to offer to produce the same after-tax return as the municipal.

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RateTax Marginal1

Yield MunicipalETY

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• If an investor is in the 28 % marginal tax bracket, a taxable investment yield of 8 % has an after-tax yield of 8 % × (1 – 0.28), or 5.76 %;

• An equivalent-risk municipal security offering a yield greater than 5.76 % offers the investor greater after-tax returns.

• On the other hand, a municipal bond yielding 6 % has an equivalent taxable yield of 6%/(1 – 0.28) = 8.33%.

• To earn more money after taxes, an equivalent-risk taxable investment has to offer a return greater than 8.33%.

35


Reducing Tax Liabilities• Contributions to an individual retirement account (IRA)

may qualify as a tax deduction if certain income limits are met.

• The investment returns of the IRA investment, including any income, are deferred until the funds are withdrawn from the account.

• Any funds withdrawn from an IRA are taxable as current income, regardless of whether growth in the IRA occurs as a result of capital gains, income, or both.

• The benefits of deferring taxes can dramatically compound over time.

36


Tax Deferrals on Investment• Exhibit 2.6 illustrates how $1,000 invested in an IRA at

a tax-deferred rate of 8% grows compared to funds invested in a taxable investment that returns (from bond income) 8% pre-tax.

• For an investor in the 28% bracket, this taxable investment grows at an after-tax rate of 5.76%.

• After 30 years, the value of the tax-deferred investment is nearly twice that of the taxable investment.

• The returns on this investment will grow on a tax-deferred basis and can be withdrawn, tax-free,

• If the funds are invested for at least five years and are withdrawn after the investor reaches age of 59½.

37


Effect of Tax Deferral on Investor Wealth over Time

0 10 20 30 years

8% TaxDeferred

5.76%After TaxReturn

$1,000

Investment Value

Time

$10,062.66

$5,365.91

Exhibit 2.6

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Methods of Tax Deferral• Regular IRA - tax deductible

– Tax on returns deferred until withdrawal • Roth IRA - not tax deductible

– tax-free withdrawals possible

• The Tax Reform Act of 1997 created the Roth IRA.• The Roth IRA contribution, allows up to $2,000 (to be

raised to $5,000) to be invested each year; the returns on this investment will grow on a tax-deferred basis and can be withdrawn, tax-free.

• The Roth IRA is subject to limitations based on the investor’s annual income, but the income ceiling is much higher than that for the regular IRA.

39


Methods of Tax Deferral• Cash value life insurance – funds accumulate

tax-free until they are withdrawn.– Employee contributions are matched by employer

donations (up to a specified limit), thus allowing the employees to double their investment with little risk.

– The drawback to such investments, however, is that early withdrawals (before age 591⁄2) are taxable and subject to an additional 10 % early withdrawal tax.

• Tax Sheltered Annuities– Some investors may want to exclude certain

investments from their portfolio solely on the basis of personal preferences.

40


Legal and Regulatory Factors• Limitations or penalties on withdrawals

– Such regulations may make such investments unattractive for investors with substantial liquidity needs in their portfolios.

• Fiduciary responsibilities - “prudent man” rule– The fiduciary must make investment decisions in

accordance with the owner’s wishes; a properly written policy statement assists this process.

• Investment laws prohibit insider trading– Insider trading involves the purchase and sale of

securities on the basis of important information that is not publicly known. 41


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

42


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 importance of diversification

43


The Importance of Asset Allocation• An investment strategy is based on four

decisions1. What asset classes to consider for investment

2. What normal or policy weights to assign to each eligible class

3. Determining the allowable allocation ranges based on policy weights

4. What specific securities to purchase for the portfolio

44


The Importance of Asset Allocation

• 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

45


Asset Allocation

• Rather than present strict percentages, asset allocation is usually expressed in ranges.

• This allows the investment manager some freedom, based on his or her reading of capital market trends, to invest toward the upper or lower end of the ranges.

46


Asset Allocation• Suppose a policy statement requires that common stocks

be 60 % to 80 % of the value of the portfolio and that bonds should be 20 % to 40 % of the portfolio’s value.

• If a manager is particularly bullish about stocks, she will increase the allocation of stocks toward the 80 % upper end of the equity range and decrease bonds toward the 20 % lower end of the bond range.

• Should she be more optimistic about bonds, that manager may shift the allocation closer to 40 % of the funds invested in bonds with the remainder in equities.

47


Asset Allocation• Ibbotson and Kaplan found that, across a

sample of funds, about 40 % of the difference in fund returns is explained by differences in asset allocation policy.

• They divided the policy return by the actual fund return (which includes the effects of varying from the policy weights and security selection).

• Thus, a fund that was passively invested at the target weights would have a ratio value of 1.0, or 100 %. 48


Asset Allocation• A fund managed by someone with skill in market

timing (for moving in and out of asset classes) and security selection would have a ratio less than 1.0 (or less than 100 %).

• The manager’s skill would result in a policy return less than the actual fund return.

• Because of market efficiency, fund managers practicing market timing and security selection, on average, have difficulty surpassing passively invested index returns, after taking into account the expenses and fees of investing.

49


Asset Allocation• The asset allocation decision explains an

average of 40 % of the variation in fund returns.

• For a single fund, asset allocation explains 90 % of the fund’s variation in returns over time and slightly more than 100 % of the average fund’s level of return.

• Good investment managers may add some value to portfolio performance, but the major source of investment return—and risk—over time is the asset allocation decision.

50


THE EFFECT OF TAXES AND INFLATION ON INVESTMENT RETURNS

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• It indicates how an investment of $1 would have grown over the 1926 to 2001 period.

• It examines how investment returns are affected by taxes and inflation.

• Focusing first on stocks, funds invested in 1926 in the S&P 500 would have averaged a 10.7 percent annual return by the end of 2001. Unfortunately, this return is unrealistic because if the funds were invested over time, taxes would have to be paid and inflation would erode the real purchasing power of the invested funds.

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• Except for tax-exempt investors and tax-deferred accounts, annual tax payments reduce investment returns. Incorporating taxes into the analysis lowers the after-tax average annual return of a stock investment to 7.9 %.

• But the major reduction in the value of our investment is caused by inflation.

• The real after tax average annual return on a stock over this time frame was only 4.7 %, which is quite a bit less than our initial unadjusted 10.7 % return!

53


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.

• Inflation and taxes have a major impact on returns

• Returns on Treasury Bills have barely kept pace with inflation

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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 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

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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

56


Asset Allocation and Cultural Differences

• Non-U.S. investors make their asset allocation decisions in much the same manner; but because they face different social, economic, political, and tax environments, their allocation decisions differ from those of U.S. investors.

• The equity allocations vary dramatically from 79% in Hong Kong to 37 % in Japan and only 8% in Germany.

• The average age of the population is highest in Germany and Japan and lowest in the United States and the United Kingdom, which helps explain the greater use of equities in the latter countries.

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• 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

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• The cost of living in the United Kingdom has increased at a rate more than 4.5 times that of Germany; this inflationary bias in the U.K. economy favors equities in U.K. asset allocations.

• The general economic environment, as well as demographics, has an effect on the asset allocation in a country.

• The need to invest in equities for portfolio growth is less in Germany, where workers receive generous state pensions.

• Germans tend to show a cultural aversion to the stock market: Many Germans are risk averse and consider stock investing a form of gambling.

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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

61


The InternetInvestments Online

www.ssa.gov

www.ibbotson.com

www.mfea.com

www.mfea.com/planidx.html

www.asec.com

www.cccsedu.org/home.html

www.aimr.org

www.iafp.org

www.amercoll.edu

www.idfp.org

www.napfa.org

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http://www.ssa.gov/

http://www.ibbotson.com/

http://www.mfea.com/

http://www.mfea.com/planidx.html

http://www.asec.com/

http://www.cccsedu.org/home.html

http://www.aimr.org/

http://www.iafp.org/

http://www.amercoll.edu/

http://www.idfp.org/

http://www.napfa.org/

Appendix Objectives and Constraints of

Institutional Investors

• Mutual Funds – pool investors funds and invests them in financial assets as per its investment objective

63


Pension Funds• Receive contributions from the firm, its

employees, or both and invests those funds• Defined Benefit – promise to pay retirees

a specific income stream after retirement• Defined Contribution – do not promise a

set of benefits. Employees’ retirement income is not an obligation of the firm

64


Endowment FundsThey represent contributions made to

charitable or educational institutions

65


Insurance Companies• Life Insurance Companies

– earn rate in excess of actuarial rate

– growing surplus if the spread is positive

– fiduciary principles limit the risk tolerance

– liquidity needs have increased

– tax rule changes

66


Insurance Companies• Nonlife Insurance Companies

– cash flows less predictable– fiduciary responsibility to claimants– Risk exposure low to moderate– liquidity concerns due to uncertain claim

patterns– regulation more permissive

67


Banks• Must attract funds in a competitive interest

rate environment• Try to maintain a positive difference

between their cost of funds and their return on assets

• Need substantial liquidity to meet withdrawals and loan demands

• Face regulatory constraints68


Tax Example• What is the marginal tax rate for a couple,

filing jointly, if their taxable income is $20,000? $40,000? $60,000?

• What is their tax bill for each of these income levels?

• What is the average tax rate for each of these income levels?

69


Solution Tax Example• Married, filing jointly, $20,000 taxable income:

– Marginal tax rate = 15%

– Taxes due = $20,000 x .15 = $3,000

– Average tax rate = 3,000/20,000 = 15%

• Married, filing jointly, $40,000 taxable income:– Marginal tax rate = 15%

– Taxes due = $40,000 x .15 = $6,000

– Average tax rate = 6,000/40,000 = 15%

• Married, filing jointly, $60,000 taxable income:– Marginal tax rate = 28%

– Taxes due = $6,780 + .28($60,000 - $45,200)

= $6,780 + $4,144 = $10,924

– Average tax rate = 10,924/60,000 = 18.21% 70


Future topicsChapter 3

• Investment choices

• Including global assets in asset allocation decisions

71


investment

Documents

tahir khan

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asset allocation

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