Chapter -2 (Asset allocation and security selection)

Asset Allocation: Asset allocation is the process of deciding how to distribute an

investor’s wealth among:
• Different countries and
• Different asset classes
An asset class is composed of securities that have similar characteristics, attributes,
and risk–return relationships.
➢ Asset allocation is a component of portfolio management.
➢ Asset allocation strategy depends on an investor’s policy statement (add: risk
tolerance, goals, time horizon).

Individual investor life cycle:

1. Serious investment program starts after fulfilling basic insurance and cash
reserve needs.
2. Investment strategies of individuals change over their lifetime
(accumulation, consolidation and spending or gifting phase)
3. Some general traits affect most investors over the life-cycle

Investment Strategies over an Investor’s Lifetime / Life Cycle Investment

Phases:
1. Accumulation Phase: Individuals in the early to middle years of their working
careers are in the accumulation phase, where they are attempting to accumulate
assets to satisfy short-term goals like a down payment for a house or a car and
longer-term goals like children’s college education and retirement.
➢ In this phase, typically, investor’s net worth is small, and have heavy debt.
➢ Here investor’s make relatively high-risk and long-term investments in the
hopes of making above-average nominal returns overtime.
2. Consolidation Phase: Individuals in the consolidation phase are typically past
the midpoint of their careers and perhaps have paid have paid off much or all of
their outstanding debts. In this phase, earnings exceed expenses, and the excess can
be invested.
Here, short-term goals include vacations, child’s education needs and long-term
goal includes retirement.
The typical investment horizon for this phase is 20 to 30 years and so moderately
risky investments are attractive. As individuals in this phase are concerned about
capital preservation, they do not want to take abnormally high risks.

3. Spending or Gifting Phase: This phase typically begins when individuals

retire. Living expenses are covered by social security income and income from
prior investments, including employer pension plans.
Here, long-term goal includes estate planning and short-term goal include lifestyle
needs, gifts or charity.
Since retirees earning years have concluded, they focus strongly on protecting their
capital and do less risky investments.
In the first two phases of the life cycle, inflation can be managed more easily. But
in the final phase, investors have already accumulated wealth, and inflation
becomes a major threat. Therefore, preserving the nominal value of their capital
becomes a primary goal.

Why Investment Strategies Change Over an Investor’s Lifetime:

Investment strategies change over a person’s lifetime because their financial goals,
income levels, responsibilities, and risk-taking ability change across the three
life-cycle phases.
• In the accumulation phase, individuals have low net worth and high debt,
so they invest in higher-risk, long-term assets to grow wealth for future
goals like buying a house, children’s education, and retirement.
 • In the consolidation phase, income rises and perhaps have paid have paid
off much or all of their outstanding debts. Investors now focus on moderate-
risk investments, while concerning about capital preservation.
• In the spending or gifting phase, individuals retire, earnings stop, and
living expenses depend on past savings. Therefore, they shift to low-risk
investments to protect capital and meet lifestyle needs.
Thus, investment strategies change over time because investors’ goals, risk
tolerance, cash-flow needs, and ability to bear losses evolve with age and life
circumstances.

The Portfolio Management Process:

1. Policy Statement: A road map for investment decisions that clearly states the
investor’s short-term and long-term goals, familiarity with capital market history,
and expected returns. It also includes an investor’s risk tolerance, time horizon, and
constraints.
An investor’s needs changes over time for which the policy statement must be
periodically reviewed and updated.
What is the goal they attain through policy statement? Why a Policy
Statement is Needed?
A policy statement does not guarantee success but does provide discipline for the
investment process and reduce the possibility of making hasty, inappropriate
decisions and unrealistic expectations.
There are two important reasons for constructing a policy statement:
First, it helps the investor decide on realistic investment goals after learning about
the financial markets and the risks of investing;
Second, it creates a standard by which to judge the performance of the portfolio
manager.
Input to the policy statement:
i. Investment Objectives: The investment objectives are an investor’s investment
goals that are expressed in terms of both risk and returns.
Risk tolerance of an investor depends on:
• Insurance coverage and cash reserve.
• Individual’s family situation such as marital status, number of children or
family members, ages of children etc.
• Investor’s age.
• Current net worth and future income expectations.
A person’s return objective may be stated-
▪ In terms of an absolute or a relative percentage return, or
▪ In terms of a general goal, such as capital preservation, current
income, capital appreciation, or total return.
Here,
A. Capital preservation focuses on minimizing the risk of loss and maintaining the
purchasing power of the investment
B. Current income means the investor wants to generate spendable income from
the portfolio rather than capital gains.
C. Capital appreciation aims to grow the portfolio’s real value over time, mainly
through capital gains.
D. Total return combines both capital gains and reinvesting current income to
increase overall portfolio value.

ii. Investment Constraints include:

• Liquidity needs: Investors may need cash for near-term expenses, so they
require liquid assets that can be sold quickly at fair value.
• Investment time horizon: Long time horizons allow taking more risk and
needing less liquidity, while short horizons require safer and more liquid
investments.
 • Tax factors: Taxes reduce actual returns, so investors must consider how
interest, dividends, and other income will be taxed when choosing
investments.
• Legal and regulatory constraints: Laws and regulations can limit what an
investor is allowed to buy or how they can invest, so portfolios must follow
these rules.
• Unique needs and preferences: Investors may --
➢ Avoid certain industries,
➢ have ethical preferences,
➢ lack time/expertise, or
➢ hold assets they are emotionally attached to.
So, portfolios must reflect these personal conditions.

2. Examine current and projected financial, economic, political, and social

conditions: Here the focus is on short-term and intermediate-term expected
conditions to use in constructing a specific portfolio.
3. Implement the plan by constructing the portfolio: Here the focus is on
meeting the investor’s needs at minimum risk levels.
4. Feedback Loop: Here the focus is on monitoring and updating an investor’s
needs, environmental conditions and evaluating portfolio performance.

Understanding and Articulating Realistic Investment Goals of an Investor:

For a realistic goal:
Performance of the investment is necessary.
Setting standards is obvious to manage investment.
Along with these an Investors Should Think About:
• Real risks of an adverse financial outcome, especially in the short run.
• Emotional reactions to an adverse financial outcome.
 • Knowledge about investments and markets.
• Other capital or income sources and its importance to a portfolio and overall
financial position.
• Effects of legal restrictions on investment needs.
• Effects of unanticipated consequences of interim fluctuations in portfolio
value.
Standards for Evaluating Portfolio Performance:
A policy statement typically includes a benchmark portfolio, or comparison
standard reflecting a client’s -
➢ Risk references and
➢ Appropriate return requirements
Both the client and the portfolio manager must agree on the benchmark portfolio,
or comparison standard. The investment performance of the portfolio manager
should be compared to this benchmark portfolio.

Life Cycle Investment Goals

Near-term, high-priority goals: These are the shorter-term financial objectives
and they may include:
• Funds to make a house down payment.
• Funds to buy a new car, or take a trip.
• Funds to pay college expenses.
(Add: as these goals have short time horizons, high-risk investments are not
considered suitable for achieving them.)
Long-term, high-priority goals: These typically include financial independence,
such as ability to retire at a certain age.
As the goals are long-term in nature, higher-risk investments can help to meet these
objectives.
Lower-priority goals: These are desirable objectives but are not critical, such as:
• Ability to purchase a new car every few years.
• Redecorate the home with expensive furnishing process.
• Take a long, luxurious vacation.