Reilly-Brown-IAPM Ch.2 Asset Allocation - Points to Refresh

Chapter 2 Asset Allocation

Financial Plan Preliminaries

Have adequate insurance before you think of investing for income and growth

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


Health insurance
Disability insurance
Automobile insurance
Home/rental insurance
Liability insurance

Cash reserve

Keep adquate cash reserve

To meet emergency needs
Includes cash equivalents (liquid investments)
Equal to six months living expenses recommended by experts

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

Saving and Investment - Goals

Near-term, high-priority goals
Long-term, high-priority goals
Lower-priority goals

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


1. Policy statement

specifies investment goals and acceptable risk levels
should be reviewed periodically

2. Study current financial and economic conditions and forecast future trends
determine strategies to meet goals
requires monitoring and updating

guides all investment decisions

3. Select Securities and Construct the portfolio
allocate available funds to minimize investor’s risks and meet investment goals

4. Monitor and update
evaluate portfolio performance
Study current financial and economic conditions and forecast future trends
Monitor investor’s needs and market conditions
revise policy statement as needed
modify investment strategy accordingly


The Need For A Policy Statement

Helps investors understand their own needs, objectives, and investment constraints
Sets standards for evaluating portfolio performance
Reduces the possibility of inappropriate behavior on the part of the portfolio manager


Questions to be answered by the investor in the process of developing a policy statement:
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?
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?


Investment Objectives

Risk Tolerance
Absolute or relative percentage return
General goals
-Capital preservation
---minimize risk of real loss
-Capital appreciation
---Growth of the portfolio in real terms to meet future need
-Current income
---Focus is in generating income rather than capital gains

Investment Constraints

-Liquidity needs
---Vary between investors depending upon age, employment, tax status, etc.
-Time horizon
Influences liquidity needs and risk tolerance
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
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

Legal and Regulatory Factors

Limitations or penalties on withdrawals
Fiduciary responsibilities - “prudent man” rule
Investment laws prohibit insider trading

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

The Importance of Asset Allocation

An investment strategy is based on four decisions
What asset classes to consider for investment
What normal or policy weights to assign to each eligible class
Determining the allowable allocation ranges based on policy weights
What specific securities to purchase for the portfolio

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


Returns and Risk of Different Asset Classes

Returns on Treasury Bills have barely kept pace with inflation

Inflation and taxes have a major impact on returns
Historically, small company stocks have generated the highest returns. But the volatility of returns have been the highest too

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


Asset Allocation Summarpzed

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


Institutional Investors, Objectives and Constraints


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

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

Endowment Funds

They represent contributions made to charitable or educational institutions

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


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

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 constraints