INVESTMENT POLICY STATEMENTS AND ASSET ALLOCATION ISSUES

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Chapter 5

• INVESTMENT POLICY STATEMENTS AND ASSET ALLOCATION
  ISSUES

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Chapter 5 Questions

• What is asset allocation?
• What are four basic risk management strategies?
• How and why do investment goals change over a
  persons lifetime and circumstances?
• What are the four steps in the portfolio
  management process?

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Chapter 5 Questions

• Why is a policy statement important to the
  planning process?
• What objectives and constraints should be
  detailed in the policy statement?
• Why is investment education necessary?
• What is the role of asset allocation in
  investment planning?
• Why do asset allocation strategies differ across
  national boundaries?

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What is asset allocation?

• The process of deciding how to distribute wealth
  among asset classes, sectors, and countries for
  investment purposes.
• Not an isolated choice, but rather a component of
  the portfolio management process.

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Managing Risk

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

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Risk Management Strategies

• Risk Avoidance
• Can avoid any real chances of loss
• Generally a poor strategy except for a part of an
  overall portfolio
• Risk Anticipation
• Position part of your portfolio to protect
  against anticipated risk factors
• For example, maintain a cash reserve

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Risk Management Strategies

• Risk Transfer
• 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
• Risk Reduction
• Effective diversification and asset allocation
  strategies can reduce risk, sometimes without
  sacrificing expected return.

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Individual Investor Life Cycle

• The individual investors life cycle can often be
  described using four separate phases or stages
• Accumulation Phase
• Consolidation Phase
• Spending Phase
• Gifting Phase

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Accumulation Phase

• Early to middle years of careers
• Attempting to satisfy intermediate and long-term
  goals
• Net worth is usually small, debt may be heavy
• Long-term investment horizon means usually
  willing to take moderately high risks in order to
  make above-average returns

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Consolidation Phase

• Past career midpoint
• Have paid off much of their accumulated debt
• Earnings now exceed living expenses, so the
  balance can be invested
• Time horizon is still long-term, so moderately
  high risk investments are still attractive

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Spending Phase

• Usually begins at retirement
• Saving before, prudent spending now
• Living expenses covered by Social Security and
  retirement plans
• Changing emphasis toward preservation of capital,
  but still want investment values to keep pace
  with inflation

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Gifting Phase

• Can be concurrent with spending phase
• If resources allow, individuals can now use
  excess assets to provide gifts to other
  individuals or organizations
• Estate planning becomes important, especially tax
  considerations

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The Portfolio Management Process

• A four step process
• Construct a policy statement
• Study current financial conditions and forecast
  future trends
• Construct a portfolio
• Monitor needs and conditions

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The Portfolio Management Process

• 1. Policy statement
• Specifies investment goals and acceptable risk
  levels
• The road map that 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 that should meet goals
  within the expected environment
• Requires monitoring and updates since financial
  markets are ever-changing

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The Portfolio Management Process

• 3. Construct the portfolio
• Given the policy statement and the expected
  conditions, go about investing
• Allocate available funds to meet goals while
  managing risk

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The Portfolio Management Process

• 4. Monitor and update
• Revise policy statement as needed
• Monitor changing financial and economic
  conditions
• Evaluate portfolio performance
• Modify portfolio investments accordingly

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The Policy Statement

• Understand and articulate realistic goals
• Know yourself
• Know the risks and potential rewards from
  investments
• Learn about standards for evaluating portfolio
  performance
• Know how to judge average performance
• Adjust for risk

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The Policy Statement

• Dont try to navigate without a map!
• Important Inputs
• Investment Objectives
• Investment Constraints

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Investment Objectives

• Need to specify return and risk objectives
• Need to consider the risk tolerance of the
  investor
• Return goals need to be consistent with risk
  tolerance
• These will change over time

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Investment Objectives

• Possible broad goals
• Capital preservation
• Maintain purchasing power
• Minimize the risk of loss
• Capital appreciation
• Achieve portfolio growth through capital gains
• Accept greater risk

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Investment Objectives

• Current income
• Look to generate income rather than capital gains
• May be preferred in spending phase
• Relatively low risk
• Total return
• Combining income returns and reinvestment with
  capital gains
• Moderate risk

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Investment Constraints

• These factors may limit or at least impact the
  investment choices
• Liquidity needs
• How soon will the money be needed?
• Time horizon
• How able is the investor to ride out several bad
  years?
• Legal and Regulatory Factors
• Legal restrictions often constrain decisions
• Retirement regulations

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Investment Constraints

• Tax Concerns
• Realized capital gains vs. Ordinary income?
• Taxable vs. Tax-exempt bonds?
• Regular IRA vs. Roth IRA?
• 401(k) and 403(b) plans
• Unique needs and preferences
• Perhaps the investor wishes to avoid types of
  investments for ethical reasons

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Investment Education

• The type of information necessary to construct a
  good policy statement is neither common sense
  or common knowledge.
• Many investors fail to diversify.
• Many fail to plan completely.
• Data indicates that many Americans have greatly
  under-invested for the future.
• The bottom line If you do not plan for the
  future, you will likely not be prepared for it.

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Asset Allocation Decisions

• Four decisions in an investment strategy
• What asset classes should be considered?
• What should be the normal weight for each asset
  class?
• What are the allowable ranges for the weights?
• What specific securities should be purchased?

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The Importance of Asset Allocation

• The asset allocation decision (which classes and
  at what weights) is very important. Using fund
  data
• About 90 of return variability over time can be
  explained by asset allocation.
• About 40 of the differences between returns can
  be explained by differences in asset allocation.
• Asset allocation is thus the major factor that
  drives portfolio risk and return.

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Risk/Return History and Asset Allocation

• Looking at return data on various asset classes
  indicate some important factors for investors
• Over long time horizons, stocks have always
  outperformed low-risk investments.
• So the additional risk of stock investing (higher
  return standard deviations) over shorter time
  horizons seems to all but disappear over time.
• Need to consider real investment returns over
  taxes and costs

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Asset Allocation and Cultural Differences

• Differences in social, political, and tax
  environments influence asset allocation.
• For instance, 58 of pension fund assets are
  invested in equities in the U.S.
• 78 in equities in United Kingdom, where high
  average inflation impacts this choice
• 8 in equities in Germany, where generous
  government pensions and greater risk aversion
  seem to play a strong role