Chapter 2 The Asset Allocation Decision
Chapter 2 The Asset Allocation Decision
Chapter 2 The Asset Allocation Decision
to accompany
Chapter 2
Saif Ullah
Economist_of_Pakistan@Yahoogroups.com
Saifullah271@yahoo.com
+923216633271
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?
Chapter 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 persons lifetime and
circumstances?
Why do asset allocation strategies differ
across national boundaries?
Individual Investor
Financial Plan Preliminaries
Insurance
Life insurance
Individual Investor
Financial Plan Preliminaries
Insurance
Life insurance
Term life insurance - death benefit
only, increasing premium at renewal
Cash value life insurance - death
benefit plus savings plan
Individual Investor
Financial Plan Preliminaries
Insurance
Health insurance - medial bills
Individual Investor
Financial Plan Preliminaries
Insurance
Disability insurance - income
Individual Investor
Financial Plan Preliminaries
Insurance
Property insurance - your home or
automobile
Individual Investor
Financial Plan Preliminaries
Insurance
Liability insurance - damage to
others or their property
Individual Investor
Financial Plan Preliminaries
Cash reserve
Individual Investor
Financial Plan Preliminaries
Cash reserve
To meet emergency needs
Six-month living expense reserve
Liquid investments
Easily converted to cash without loss
of value
Individual Investor
Life Cycle
Accumulation phase
Consolidation phase
Spending phase
Gifting phase
Figure 2.1
Accumulation
Phase
25
35
45
55
65
Age
75
Figure 2.2
Capital appreciation
capital gains to provide real growth over time for future
need
aggressive strategy with accepted risk
Current income
generate spendable funds
Investment Constraints
Liquidity needs
near-term goals
Time horizon
longer time horizon favors risk acceptability
short time horizon favors less risky investments
because losses are harder to overcome in a short
time frame
Investment Constraints
Tax concerns
interest and dividends taxed at investors
marginal tax rate
capital gains may be unrealized
basis and gain or loss realized
revisions to capital gains tax rates
tradeoff with diversification needs for
employers stock holdings
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
Municipal Yield
ETY
1 Marginal Tax Rate
Investment
Value
$10,063
8% Tax
Deferred
$5,365
5.76%
After Tax
Return
$1,000
0
10
20
Time
30 years
The Importance
of Asset Allocation
The Importance
of Asset Allocation
Most (85% to 95%) of the overall
investment return is due to the first two
decisions, not the selection of individual
investments
Figure 2.6
12
10
8
6
4
Before
Taxes
Common Stocks
After After
Taxes Taxes
and
Inflation
Long-Term
Government
Bonds
Treasury Bills
2
0
-2
Municipal Bonds
Summary
Develop an investment policy statement
Identify investment needs, risk tolerance, and
familiarity with capital markets
Identify objectives and constraints
Investment plans are enhanced by accurate
formulation of a policy statement
Summary
Asset allocation determines long-run returns
and risk
Success depends on construction of the policy
statement
The Internet
Investments Online
www.ssa.gov
www.amercoll.edu
www.ibbotson.com
www.idfp.org
www.mfea.com
www.napfa.org
www.mfea.com/planidx.html
www.asec.com
www.cccsedu.org/home.html
www.aimr.org
www.iafp.org
Appendix Chapter 2
Objectives and Constraints of
Institutional Investors
Mutual Funds
Legal constraints
Investment choices by fund
managers
Pension Funds
Defined benefit pension plans
actuarial status
liquidity constraint
governed by ERISA
Pension Funds
Defined contribution pension
plans
liquidity and time horizon
governed by ERISA
Endowment Funds
Charitable or educational
institutions
need for current income
need for increasing future
income
Insurance Companies
Life Insurance Companies
earn rate in excess of actuarial rate
growing surplus
limited by fiduciary principles
liquidity needs
tax rule changes
Insurance Companies
Nonlife Insurance Companies
cash flows less predictable
fiduciary responsibility to claimants
liquidity concerns
regulation more permissive
Banks
Must attract funds in a competitive
interest rate environment
tries to maintain a positive difference
between its cost of funds and its return
on assets
liquidity needs
regulatory constraints
End of Chapter 2
The Asset Allocation Decision
Future topics
Chapter 3
Investment choices
Including global assets in asset
allocation decisions