Chapter 5_05.ppt

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Chapter 5_05.ppt

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

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