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Chapter 05
1. Chapter 5
INVESTMENT POLICY
STATEMENTS AND ASSET
ALLOCATION ISSUES
2. Chapter 5 Questions
โข What is asset allocation?
โข What are four basic risk management
strategies?
โข How and why do investment goals
change over a personโs lifetime and
circumstances?
โข What are the four steps in the portfolio
management process?
3. Chapter 5 Questions
โข Why is a policy statement important to the
planning process?
โข What objectives and constraints should be
detailed in the policy statement?
โข Why is investment education necessary?
โข What is the role of asset allocation in
investment planning?
โข Why do asset allocation strategies differ
across national boundaries?
4. What is asset allocation?
โข The process of deciding
how to distribute wealth
among asset classes,
sectors, and countries
for investment
purposes.
โข Not an isolated choice,
but rather a component
of the portfolio
management process.
5. Managing Risk
Since risk drives
expected return,
investing involves
managing risk rather
than managing
return.
6. Risk Management Strategies
โข Risk Avoidance
โ Can avoid any real chances of loss
โ Generally a poor strategy except for a part
of an overall portfolio
โข Risk Anticipation
โ Position part of your portfolio to protect
against anticipated risk factors
โ For example, maintain a cash reserve
7. Risk Management Strategies
โข Risk Transfer
โ Insurance and other investment vehicles can
allow for the transfer of risk, often at a price, to
another investor who is willing to bear the risk
โข Risk Reduction
โ Effective diversification and asset allocation
strategies can reduce risk, sometimes without
sacrificing expected return.
8. Individual Investor Life Cycle
The individual investors life cycle can
often be described using four separate
phases or stages:
โข Accumulation Phase
โข Consolidation Phase
โข Spending Phase
โข Gifting Phase
9. Accumulation Phase
โข Early to middle years of careers
โข Attempting to satisfy intermediate and long-
term goals
โข Net worth is usually small, debt may be
heavy
โข Long-term investment horizon means usually
willing to take moderately high risks in order
to make above-average returns
10. Consolidation Phase
โข Past career midpoint
โข Have paid off much of their
accumulated debt
โข Earnings now exceed living expenses,
so the balance can be invested
โข Time horizon is still long-term, so
moderately high risk investments are
still attractive
11. Spending Phase
โข Usually begins at retirement
โข Saving before, prudent spending now
โข Living expenses covered by Social
Security and retirement plans
โข Changing emphasis toward
preservation of capital, but still want
investment values to keep pace with
inflation
12. Gifting Phase
โข Can be concurrent with spending phase
โข If resources allow, individuals can now
use excess assets to provide gifts to
other individuals or organizations
โข Estate planning becomes important,
especially tax considerations
13. The Portfolio Management
Process
A four step process:
1. Construct a policy statement
2. Study current financial conditions and
forecast future trends
3. Construct a portfolio
4. Monitor needs and conditions
14. The Portfolio Management
Process
1. Policy statement
โ Specifies investment goals and acceptable
risk levels
โ The โroad mapโ that guides all investment
decisions
15. The Portfolio Management
Process
2. Study current financial and economic
conditions and forecast future trends
โ Determine strategies that should meet
goals within the expected environment
โ Requires monitoring and updates since
financial markets are ever-changing
16. The Portfolio Management
Process
3. Construct the portfolio
โ Given the policy statement and the
expected conditions, go about investing
โ Allocate available funds to meet goals
while managing risk
17. The Portfolio Management
Process
4. Monitor and update
โ Revise policy statement as needed
โ Monitor changing financial and economic
conditions
โ Evaluate portfolio performance
โ Modify portfolio investments accordingly
18. The Policy Statement
โข Understand and articulate realistic goals
โ Know yourself
โ Know the risks and potential rewards from
investments
โข Learn about standards for evaluating portfolio
performance
โ Know how to judge average performance
โ Adjust for risk
19. The Policy Statement
โข Donโt try to navigate
without a map!
โข Important Inputs:
โ Investment
Objectives
โ Investment
Constraints
20. Investment Objectives
Need to specify return
and risk objectives
โ Need to consider the
risk tolerance of the
investor
โ Return goals need to
be consistent with
risk tolerance
โ These will change
over time
21. Investment Objectives
Possible broad goals:
โข Capital preservation
โ Maintain purchasing power
โ Minimize the risk of loss
โข Capital appreciation
โ Achieve portfolio growth through capital
gains
โ Accept greater risk
22. Investment Objectives
โข Current income
โ Look to generate income rather than capital gains
โ May be preferred in โspending phaseโ
โ Relatively low risk
โข Total return
โ Combining income returns and reinvestment with
capital gains
โ Moderate risk
23. Investment Constraints
These factors may limit or at least impact the
investment choices:
โข Liquidity needs
โ How soon will the money be needed?
โข Time horizon
โ How able is the investor to ride out several bad
years?
โข Legal and Regulatory Factors
โ Legal restrictions often constrain decisions
โ Retirement regulations
24. Investment Constraints
โข Tax Concerns
โ Realized capital gains vs. Ordinary income?
โ Taxable vs. Tax-exempt bonds?
โ Regular IRA vs. Roth IRA?
โ 401(k) and 403(b) plans
โข Unique needs and preferences
โ Perhaps the investor wishes to avoid types of
investments for ethical reasons
25. Investment Education
โข The type of information necessary to
construct a good policy statement is neither
โcommon senseโ or โcommon knowledge.โ
โข Many investors fail to diversify.
โข Many fail to plan completely.
โข Data indicates that many Americans have
greatly under-invested for the future.
โข The bottom line: If you do not plan for the
future, you will likely not be prepared for it.
26. Asset Allocation Decisions
Four decisions in an investment strategy:
โข What asset classes should be considered?
โข What should be the normal weight for each
asset class?
โข What are the allowable ranges for the
weights?
โข What specific securities should be
purchased?
27. The Importance of Asset
Allocation
โข The asset allocation decision (which classes
and at what weights) is very important. Using
fund data:
โ About 90% of return variability over time can be
explained by asset allocation.
โ About 40% of the differences between returns can
be explained by differences in asset allocation.
โข Asset allocation is thus the major factor that
drives portfolio risk and return.
28. Risk/Return History and
Asset Allocation
Looking at return data on various asset classes
indicate some important factors for investors:
โ Over long time horizons, stocks have always
outperformed low-risk investments.
โ So the additional risk of stock investing (higher
return standard deviations) over shorter time
horizons seems to all but disappear over time.
โ Need to consider real investment returns over
taxes and costs
29. Asset Allocation and Cultural
Differences
โข Differences in social, political, and tax
environments influence asset allocation.
โข For instance, 58% of pension fund assets are
invested in equities in the U.S.
โ 78% in equities in United Kingdom, where high
average inflation impacts this choice
โ 8% in equities in Germany, where generous
government pensions and greater risk aversion
seem to play a strong role