Investment Decision and Portfolio Management (ACFN 632)

Investment Decision and
Portfolio
Management
(ACFN 632)
Chapter 2
Asset allocation decision
1
What is Asset Allocation?
• Asset Allocation
– process of deciding how to distribute an investor’s
wealth among different countries and asset classes
for investment purposes
• Asset Class
– group of securities that have similar
characteristics, attributes, and risk/return
relationships
2
Portfolio Management
Process:
Policy Statement
– Specifies investment goals and acceptable
risk
levels
– Should be reviewed periodically
– Guides all investment decisions
3
Portfolio Management
Process
4
Need for Policy Statement
• Understand investor’s needs and articulate realistic
investment objectives and constraints
– What are the real risks of an adverse financial

outcome, and what emotional reactions will I have?
– How knowledgeable am I about investments and

the financial markets?
– What, if any, legal restrictions affect me?
5
Need for Policy Statement
• Understand investor’s needs and articulate
realistic investment objectives and constraints …
– What other capital or income sources do I have?
– How important is this particular portfolio to my

overall financial position?
– How would any unanticipated portfolio value
change
might affect my investment policy?
6
Need for a Policy Statement
• Sets standards for evaluating portfolio performance
– Provides a comparison standard in judging the
performance of the portfolio manager
– Benchmark portfolio or comparison standard is used to
reflect the risk and return objectives specified in the policy
statement
– Should act as a starting point for periodic portfolio review
and client communication with the manager
7
Need for a Policy Statement
• Other Benefits
– Reduces possibility of inappropriate or unethical behavior
of the portfolio manager.
– Helps create faultless transition from one money manager
to another without costly delays.
– Provides the framework to help resolve any potential
disagreements between the client and the manager.
108
Input to the Policy Statement
• Constructing the policy statement begins with a

profile analysis of the investor’s current and
future financial situations and a discussion of
investment objectives and constraints.
9
Input to the Policy Statement
• Objectives
– Risk
– Return
• Constraints
– Liquidity, time horizon, tax factors, legal and
regulatory constraints, and unique needs
and preferences
10
Investment Objectives
• Risk Objectives
 Should be based on investor’s ability to take risk
and willingness to take risk.
Risk tolerance depends on an investor’s current
net worth and income expectations and age.
• More net worth allows more risk taking
• Younger people can take more risk
Careful analysis of client’s risk tolerance should
precede any discussion of return objectives.
11
• Return Objectives
– May be stated in terms of an absolute or a
relative percentage return
– Capital Preservation:
• Minimize risk of real losses
12
– Capital Appreciation: Growth of the portfolio in
real terms to meet future need
– Current Income: Focus is in generating income
rather than capital gains
– Total Return: Increase portfolio value by
capital gains and by reinvesting current
income with moderate risk exposure
13
Investment Constraints:
Liquidity
– Liquidity
• Vary between investors; depending upon

age,
employment, tax status, etc.
• Planned vacation expenses and house
down payment are some of the liquidity
needs.
14
Investment Constraints: Time
– Time
• Influences liquidity needs and risk tolerance.
• Longer investment horizons generally requires

less
liquidity and more risk tolerance.
• Two general time horizons are pre-retirement
and
post-retirement periods.
15
Investment Constraints: Taxes
– Interest Income: 100% of all interest income is taxed at
an
investor’s marginal tax rate.
– Interest Income: 100% of all interest income is taxed at
an
investor’s marginal tax rate, in Ethiopia flat rate of 5%.
– Capital gains are also taxed
– Investment on government securities are tax exempt
16
Personal Constraints:
Unique Needs &
• Preferences
Personal preferences such as socially conscious 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 investor’s needs- may differ from
personal 201
7
Importance of Asset Allocation
• An investment strategy is based on four decisions
– What asset classes to consider for investment
– What policy weights to assign to each eligible class
– What allocation ranges are allowed based on
policy weights
– What specific securities to purchase for the
portfolio
Measuring risk by the 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
18
Portfolio Objectives and
•
Policies
Capital Preservation Objective
– Low-risk, conservative investment strategy
– Emphasis on current income and capital preservation
• Capital Growth Objective

– Higher-risk investment strategy
– Emphasis on more speculative investments
• Tax Efficient Objective

– Emphasis on capital gains and longer holding periods to
defer
19
income taxes
Approaches to Asset Allocation
• Fixed-Weightings Approach: asset allocation plan in which
a fixed percentage of the portfolio is allocated to each
asset category
• Flexible-Weightings Approach: asset allocation plan in which

weights for each asset category are adjusted periodically
based on market analysis
• Tactical Approach: asset allocation plan that uses stock-

index futures and bond futures to change asset allocation
based on market behavior 20
Alternative Asset Allocation
21
Applying Asset Allocation
• Consider impact of economic and other factors on
your investment objective.
• Design your asset allocation plan for the long haul
• Stress capital preservation.
• Provide for periodic reviews to maintain

consistency
with changing investments goals.
22
End
2
3

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Investment Decision and

– Guides all investment decisions

– What are the real risks of an adverse financial

– How knowledgeable am I about investments and

– What, if any, legal restrictions affect me?

– How important is this particular portfolio to my

• Constructing the policy statement begins with a

investment objectives and constraints.

• Vary between investors; depending upon

• Longer investment horizons generally requires

– Investment on government securities are tax exempt

Measuring risk by the probability of not meeting your

• Capital Growth Objective

• Tax Efficient Objective

• Flexible-Weightings Approach: asset allocation plan in which

• Tactical Approach: asset allocation plan that uses stock-

• Design your asset allocation plan for the long haul

• Stress capital preservation.

• Provide for periodic reviews to maintain

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