CHAPTER 2
Asset
Allocation
and Security
Decision
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
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
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 2-2
What is Asset Allocation?
• Investor:
• Depending on the type of investors,
investment objectives and constraints
vary
• Individual investors
• Institutional investors
3
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 2-3
2.1 Individual Investor Life Cycle
• Financial plans and investment needs are
different for each individual, and they
change over a person’s life cycle
• How individuals structure their financial
plan should be related to their age,
financial status, future plans, risk aversion
characteristics, and needs
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 2-4
2.1.1 The Preliminaries (slide 1 of 2)
• Insurance
• Life insurance
• The death benefit paid by the insurance company can help
pay medical bills and funeral expenses and provide cash that
family members can use to maintain their lifestyle, retire debt,
or invest for future needs
• Health insurance
• Helps to pay medical bills
• Disability insurance
• Provides continuing income should you become unable to
work
• Automobile and home (or rental) insurance
• Provides protection against accidents and damage to cars or
residences
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 2-5
2.1.1 The Preliminaries (slide 2 of 2)
• Cash Reserve
• Helps to meet events such as emergencies
• Reduces the likelihood of being forced to sell
investments at inopportune times
• Experts recommend a cash reserve equal to
about six months’ living expenses
• Funds should be in investments easily
convertible to cash, such as money market or
short-term bond mutual funds
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 2-6
2.1.2 Investment Strategies over an
Investor’s Lifetime (slide 1 of 4)
• Life Cycle Phases
• Accumulation phase
• Early to middle years of working career
• Long investment time horizon and future earning ability
• Individuals typically willing to make relatively high-risk
investments in the hopes of making above-average nominal
returns over time
• Consolidation phase
• Past midpoint of careers
• Earnings greater than expenses
• Typical investment horizon for this phase is still long (20 to 30
years), so moderately high-risk investments are attractive
• Individuals in this phase are concerned about capital
preservation and do not want to take abnormally high risks
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 2-7
2.1.2 Investment Strategies over an
Investor’s Lifetime (slide 2 of 4)
• Spending phase
• Begins after retirement
• Living expenses are covered by Social Security income and
income from prior investments, including employer pension
plans
• The overall portfolio may be less risky than in the consolidation
phase, but investors still need some risky growth investments,
such as common stocks, for inflation protection
• Gifting phase
• May be concurrent with the spending phase
• Excess assets can be used to provide financial assistance to
relatives or to establish charitable trusts as an estate planning
tool to minimize estate taxes
• Exhibits 2.1, 2.2
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 2-8