The Asset Allocation Decision

AFTER READING THIS CHAPTER YOU WILL BE ABLE TO

1. CONCEPT
2. INDIVIDUAL INVESTOR’S LIFE CYCLE
3. PORTFOLIO MANAGEMENT PROCESS
4. NEED FOR A POLICY STATEMENT
5. INPUT TO THE POLICY STATEMENT -
a. INVESTMENT OBJECTIVES AND
b. INVESTMENT CONSTRAINTS
6. CONSTRUCTING THE POLICY STATEMENT
7. IMPORTANCE OF ASSET ALLOCATION.

Ref.
Investment Analysis & Portfolio Management_Reilly and Brown_11th-page-
61-96
Asset allocation is the process of deciding how to distribute an investor’s
wealth among different countries and asset classes for investment
purposes. An asset class is composed of securities that have similar
characteristics, attributes, and risk–return relationships.

A broad asset class, such as “bonds,” can be divided into smaller asset
classes, such as Treasury bonds, corporate bonds, and high-yield bonds. We
will see that, in the long run, the highest compounded returns will most
likely accrue to investors with larger exposures to risky assets.

An asset allocation strategy depends on the investor’s policy statement,

which includes the investor’s goals or objectives, constraints, and
investment guidelines. What we mean by an “investor” can range from an
individual account to trustees over seeing a corporation’s multibillion-dollar
pension fund, a university endowment, or an insurance company portfolio.
The point is that it is critical for an investor to develop a policy statement
before making long-term investment decisions.

INDIVIDUAL INVESTOR’S LIFE CYCLE

The Preliminaries

Before embarking on an investment program, we need to make sure other

needs are satisfied. No serious investment plan should be started until a
potential investor has a safety net to cover living expenses should the
unexpected occur.

Insurance Life insurance should be a component of any financial plan. Life

insurance protects loved ones against financial hardship should death occur
before our financial goals are met. Therefore, one of the first steps in
developing a financial plan is to purchase adequate life insurance coverage.
Lack of insurance coverage can ruin the best-planned investment program.

Cash Reserve Emergencies, job layoffs, and unforeseen expenses happen,

and good invest ment opportunities emerge. It is important to have a cash
reserve to help meet such events. In addition, a cash reserve reduces the
likelihood of being forced to sell investments at inop portune times to cover
unexpected expenses. Calling it a “cash” reserve means the funds should be
in investments you can easily convert to cash, with little chance of a loss in
value, such as money market or short-term bond mutual funds.

INVESTMENT STRATEGIES OVER AN INVESTOR’S LIFETIME

Assuming that basic insurance and cash reserve needs are met, individuals
can start a serious investment program.

Accumulation Phase Individuals in the early to middle years of their

working careers are in the accumulation phase, wherein they are
attempting to accumulate assets to satisfy fairly imme diate needs (for
example, a down payment for a house) or longer-term goals
(children’scollege education, retirement). Typically, their net worth is small,
and debt from car loans or their own past college loans may be heavy. As a
result of their long investment time horizon and future earn ing ability,
individuals in the accumulation phase are typically willing to make relatively
high-risk investments in the hopes of making above-average nominal
returns overtime.

Consolidation Phase Individuals in the consolidation phase are typically

past the midpoint of their careers, have paid off much or all of their
outstanding debts, and perhaps have paid, or have the assets to pay, their
children’s college bills. Earnings exceed expenses, and the excess can be
invested for future retirement or estate planning needs. The typical
investment horizon for this phase is still long (20 to 30 years), so moderately
high-risk investments are attractive. Still, because individuals in this phase
are concerned about capital preservation, they do not want to take
abnormally high risks.
Spending Phase The spending phase typically begins when individuals
retire. Living expenses are covered by Social Security income and income
from prior investments, including employer pension plans. Because their
earning years have concluded ), they are very conscious of protecting their
capital. Still, they must balance their desire to preserve the nominal value of
their savings with the need to protect themselves against a decline in the
real value of their savings due to inflation.

Gifting Phase The gifting phase may be concurrent with the spending
phase. In this stage, individuals may believe they have sufficient income and
assets to cover their current and future expenses while maintaining a
reserve for uncertainties. In such a case, 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.

PORTFOLIO MANAGEMENT PROCESS

The process of managing an investment portfolio never stops. Once the
funds are initially invested according to the plan, the emphasis changes to
evaluating the portfolio’s performance and updat ing the portfolio based on
changes in the economic environment and the investor’s needs.
The first step in the portfolio management process, as shown in Exhibit 2.3,
is for the investor to construct a policy statement that specifies the types of
risks the investor is willing to take and his or her investment goals and
constraints.

In the second step, the portfolio manager studies current financial and
economic conditions and forecasts future trends. The investor’s needs, as
reflected in the policy statement, and financial market expectations will
jointly determine the investment strategy.

The third step of the portfolio management process is to construct the

portfolio. Given the investor’s policy statement and financial market
forecasts as input, the advisors implement the investment strategy and
determine how to allocate available funds across different countries, asset
classes, and securities.

The fourth step in the portfolio management process is the continual

monitoring of the investor’s needs and capital market conditions and, when
necessary, updating of the policy statement. In turn, the investment strategy
is modified.

NEED FOR A POLICY STATEMENT

Because a policy statement guides the investment process, it is an
invaluable planning tool that will help an Investor understand his or her
needs better as well as assist an advisor or a portfolio manager in managing
a client’s funds.

Understanding and Articulating Realistic Investor Goals

Writing a policy statement helps an investor understand his or her own

needs, objectives, and investment constraints. Writing this statement
requires an investor to learn about financial markets and the risks of
investing that will prevent him or her from making inappropriate
investment decisions based on unrealistic expectations and increase the
possibility of satisfying the specific, measurable financial goals.

Standards for Evaluating Portfolio Performance

A policy statement assists in judging the performance of a portfolio

manager, which requires an objective standard; a policy statement provides
such a standard. A portfolio’s performance should be compared to
guidelines specified in the policy statement, not based on the portfolio’s
overall return.
Other Benefits

A sound policy statement protects the client against a portfolio manager’s

inappropriate investments or unethical behavior. Though legal recourse is a
possibility against such action, writing a clear and unambiguous policy
statement should reduce the possibility of such behavior.

Because a portfolio manager may be promoted or dismissed or may take a

better job, your funds may come under the management of an individual
you do not know and who does not know you. To prevent costly delays
during this transition, it is critical that you have a clearly written policy
statement that will prevent delays in monitoring and rebalancing your
portfolio and contribute to a seamless transition between money managers.

INPUT TO THE POLICY STATEMENT

Investment Objectives

The investor’s objectives are his or her investment goals, expressed in terms
of both risk and returns. (Goals should not be expressed only in terms of
returns because such an approach can lead to inappropriate investment
practices, such as high-risk strategies or excessive trading.) A client should
also become fully informed of investment risks associated with any specified
goal, including the possibility of loss. A careful analysis of the client’s risk
tolerance should precede any discussion of return objectives.

A person’s return objective may be stated in terms of an absolute or a relative

percentage return, but it may also be stated in terms of a general goal, such
as capital preservation, current income, capital appreciation, or total return

✓ Capital preservation means that investors want to minimize their risk

of loss, usually in real terms: They seek to maintain the purchasing
power of their investment. In other words, the return needs to be no
less than the rate of inflation. Generally, this is a strategy for strongly
risk-averse investors
✓ Capital appreciation is an appropriate objective for investors who
want the portfolio to grow in real terms over time to meet some future
need. Under this strategy, growth mainly occurs through capital gains.
✓ The total return strategy is similar to that of capital appreciation;
namely, the investors want the portfolio to grow over time to meet a
future need. The total return strategy seeks to increase portfolio value
by both capital gains and reinvesting current income.
Investment Constraints

In addition to the risk and return objectives, other constraints include

liquidity needs, an investment time horizon, tax factors, legal and regulatory
constraints, and unique needs and preferences.

✓ Liquidity Needs An asset is liquid if it can be quickly converted to cash at

a price close to fair market value. Generally, liquid assets involve many
traders who are interested in a fairly standardized product. Investors may
have liquidity needs that the investment plan must consider.
✓ Time Horizon Time horizon as an investment constraint briefly entered
our earlier discussion of near-term and long-term high-priority goals.
Investors with long investment horizons generally require less liquidity
and can tolerate greater portfolio risk. Investors with shorter time
horizons generally favor more liquid and less risky investments
✓ Tax Concerns Investment planning is complicated by taxes that can
seriously become overwhelming if international investments are part of
the portfolio.
✓ Legal and Regulatory Factors Both the investment process and the
financial markets are highly regulated and subject to numerous laws.
✓ Unique Needs and Preferences This category covers the unique
concerns of each investor. For example, some investors may want to
exclude certain investments solely on the basis of personal preference or
for social consciousness reasons. For example, they may request that no
firms that manufacture or sell tobacco, alcohol, pornography, or
environmentally harmful products be included in their portfolio. Some
mutual funds screen according to this type of social responsibility
criterion.

CONSTRUCTING THE POLICY STATEMENT

The purpose of Constructing the Policy Statement is to allow an investor
to communicate his or her objectives (risk and return) and constraints
(including liquidity, time horizon, tax, legal and regulatory, and unique needs
and preferences). This process gives an advisor a better chance of
implementing an investment strategy that satisfies the investor, and it is
also necessary for investors developing their own financial plans to guide
their strategy.

General guidelines suggest that investors must contemplate and answer a

specific set of questions (detailed elsewhere in the planning process) during
the construction phase.
The source highlights several common mistakes that participants often
make when developing their financial plans or investment strategies:

1. Overconcentration in Employer Stock: Many participants in employer-

sponsored retirement plans invest 30 to 40 percent of their retirement
funds in their employer's stock, which violates diversification principles
(as mutual funds are usually limited to 5 percent and firm pension plans
to 10 percent).

2. Excessive Conservatism: Investors frequently exhibit an average stock

allocation in retirement plans that is lower than it should be, meaning
they tend to be too conservative.

3. Poor Trading Practices: Studies have documented that individual

investors typically trade stocks too often (driving up commissions), sell
stocks with gains too early, and hold on to losers too long.

4. Failure to Plan: A significant first step in achieving financial success—

planning for the future—is often neglected. Americans face two related
problems: they are not saving enough to finance their retirement years,
and they have not created an investing plan for their savings after they
retire. About 60 percent of surveyed workers confess to being "behind
schedule" in planning and saving for retirement, and around 25 percent
have saved less than $50,000.

IMPORTANCE OF ASSET ALLOCATION

The asset allocation decision is a critical component of the portfolio
management process, drawing strong support from historical data and
empirical studies.

The importance of asset allocation can be briefly summarized by its

profound influence on a portfolio's returns and risk over time:

Dominant Factor in Returns: The asset allocation decision dominates the

portfolio’s returns over time. Multiple studies have found that approximately
90 percent of a fund’s returns over time can be explained by its target asset
allocation policy (normal policy weights). For a single fund, asset allocation
explains 90 percent of the fund’s variation in returns over time.

Risk and Volatility: Asset allocation is a major determinant of both the

returns and the volatility (risk) of the portfolio.
Maintaining Real Value: For taxable investments, an asset allocation
strategy must include a substantial commitment to common stocks to
ensure the portfolio maintains its real value (purchasing power) over long
time periods, especially after accounting for taxes and inflation. A strategy
relying solely on Treasury bills, while seemingly safe, may actually be riskier
when the goal is meeting long-term investment return objectives.

Role in Planning: Asset allocation is the process of deciding how to

distribute an investor’s wealth among different countries and asset classes.
This decision is a key component of the four-step portfolio management
process and is guided by the investor’s policy statement.