Chapter 2Chapter 2The Asset Allocation DecisionThe Asset Allocation Decision

Questions to be answered:Questions to be answered: What is asset allocation?What is asset allocation? What are the four steps in the What are the four steps in the

portfolio management process?portfolio management process? What is the role of asset allocation What is the role of asset allocation

in investment planning?in investment planning? Why is a policy statement Why is a policy statement

important to the planning process?important to the planning process?

Chapter 2Chapter 2The Asset Allocation DecisionThe Asset Allocation Decision

What objectives and What objectives and constraints should be detailed constraints should be detailed in a policy statement?in a policy statement?

How and why do investment How and why do investment goals change over a person’s goals change over a person’s lifetime and circumstances?lifetime and circumstances?

Why do asset allocation Why do asset allocation strategies differ across strategies differ across national boundaries?national boundaries?

Individual Investor Life Individual Investor Life CycleCycle

25 35 45 55 65 75

Net Worth

Age

Accumulation Phase

Long-term: Retirement Children’s college

Short-term: House Car

Consolidation Phase

Long-term: Retirement

Short-term:

Vacations

Children’s College

Spending Phase Gifting Phase

Long-term: Estate Planning

Short-term: Lifestyle Needs Gifts

Figure 2.1

The Portfolio Management The Portfolio Management ProcessProcess

1. Policy statement - Focus: Investor’s short-term and 1. Policy statement - Focus: Investor’s short-term and long-term needs, familiarity with capital market long-term needs, familiarity with capital market history, and expectationshistory, and expectations

2. Examine current and project financial, economic, 2. Examine current and project financial, economic, political, and social conditions - Focus: Short-term political, and social conditions - Focus: Short-term and intermediate-term expected conditions to use and intermediate-term expected conditions to use in constructing a specific portfolioin constructing a specific portfolio

3. Implement the plan by constructing the portfolio - 3. Implement the plan by constructing the portfolio - Focus: Meet the investor’s needs at the minimum Focus: Meet the investor’s needs at the minimum risk levelsrisk levels

4. Feedback loop: Monitor and update investor needs, 4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performanceenvironmental conditions, portfolio performance

Figure 2.2

Policy StatementPolicy Statement The Smith Family Portfolio’s primary focus is the The Smith Family Portfolio’s primary focus is the

production of current income, with long-term production of current income, with long-term capital appreciation a secondary consideration. capital appreciation a secondary consideration. The need for a dependable income stream The need for a dependable income stream precludes investment vehicles with even modest precludes investment vehicles with even modest likelihood of losses. Liquidity needs reinforce the likelihood of losses. Liquidity needs reinforce the need to emphasize minimum-risk investments. need to emphasize minimum-risk investments. Extensive use of short-term investment-grade Extensive use of short-term investment-grade investments is entirely justified by the expectation investments is entirely justified by the expectation that a low-inflation environment will exist that a low-inflation environment will exist indefinitely into the future. For these reasons, indefinitely into the future. For these reasons, investments will emphasize U.S. Treasury bills and investments will emphasize U.S. Treasury bills and notes, intermediate-term investment-grade notes, intermediate-term investment-grade corporate debt, and select “blue chip” stocks corporate debt, and select “blue chip” stocks whose dividend distributions are assured and whose dividend distributions are assured and whose price fluctuations are minimal.whose price fluctuations are minimal.

Standards For Evaluating Standards For Evaluating Portfolio PerformancePortfolio Performance

Benchmark portfolioBenchmark portfolio risk and returnrisk and return

Matches risk preferences and Matches risk preferences and investment needsinvestment needs analysis of risk toleranceanalysis of risk tolerance return objective goalsreturn objective goals

Realistic Investor GoalsRealistic Investor Goals Capital preservationCapital preservation

minimize risk of real lossminimize risk of real loss strongly risk-averse or funds needed soonstrongly risk-averse or funds needed soon

Capital appreciationCapital appreciation capital gains to provide real growth over time for capital gains to provide real growth over time for

future needfuture need aggressive strategy with accepted riskaggressive strategy with accepted risk

Current incomeCurrent income generate spendable fundsgenerate spendable funds

Total returnTotal return capital gains and income reinvestmentcapital gains and income reinvestment moderate risk exposuremoderate risk exposure

Investment ConstraintsInvestment Constraints

Liquidity needsLiquidity needs Time horizonTime horizon Tax concernsTax concerns

Interest and Interest and dividendsdividends

Capital gain/lossCapital gain/loss Munis - Munis -

Retirement accts (tax Retirement accts (tax deferral)deferral)

RateTax Marginal1

Yield MunicipalETY

Effect of Tax Deferral Effect of Tax Deferral on Investor Wealth on Investor Wealth

over Timeover Time

0 10 20 30 years

8% TaxDeferred

5.76%After TaxReturn

$1,000

Investment Value

Time

$10,063

$5,365

Figure 2.5

Methods of Tax DeferralMethods of Tax Deferral

Regular IRA - tax deductibleRegular IRA - tax deductible withdrawals taxablewithdrawals taxable

Roth IRA - not tax deductibleRoth IRA - not tax deductible tax-free withdrawals possibletax-free withdrawals possible

AnnuitiesAnnuities Employer’s 401(k) and 403(b) Employer’s 401(k) and 403(b)

plansplans

The Effect of Taxes and The Effect of Taxes and Inflation on Investment Inflation on Investment Returns, 1926 - 1998Returns, 1926 - 1998

-2

0

2

4

6

8

10

12Common Stocks

Long-TermGovernmentBondsTreasury Bills

Municipal Bonds

After Taxes and

Inflation

After Taxes

Before Taxes

Figure 2.6

The Effect of Taxes and The Effect of Taxes and Inflation on Returns: 1981-Inflation on Returns: 1981-

20042004

1

2

3

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

1 2 3

Before T&I After Tax After T&I

Co

mp

ou

nd

An

nu

al R

etu

rn

Legal and Regulatory Legal and Regulatory FactorsFactors

Limitations or penalties on Limitations or penalties on withdrawalswithdrawals

Fiduciary responsibilities - Fiduciary responsibilities - “prudent man” rule“prudent man” rule

Investment laws prohibit insider Investment laws prohibit insider tradingtrading

Unique Needs and Unique Needs and PreferencesPreferences

Personal preferences - socially Personal preferences - socially conscious investmentsconscious investments

Time constraints or expertise for Time constraints or expertise for managing the portfolio may require managing the portfolio may require professional managementprofessional management

Large investment in employer may Large investment in employer may require consideration of diversification require consideration of diversification needs and realistic liquidityneeds and realistic liquidity

Institutional investors needsInstitutional investors needs

The Importance The Importance of Asset Allocationof Asset Allocation

An investment strategy is based An investment strategy is based on four decisionson four decisions What asset classes to consider for What asset classes to consider for

investmentinvestment What normal or policy weights to What normal or policy weights to

assign to each eligible classassign to each eligible class The allowable allocation ranges based The allowable allocation ranges based

on policy weightson policy weights What specific securities to purchase for What specific securities to purchase for

the portfoliothe portfolio

Returns and Risk of Returns and Risk of Different Asset ClassesDifferent Asset Classes

Higher returns compensate for riskHigher returns compensate for risk Policy statements must provide Policy statements must provide

risk guidelinesrisk guidelines Measuring risk by standard Measuring risk by standard

deviation of returns over time deviation of returns over time indicates stocks are more risky indicates stocks are more risky than T-billsthan T-bills

Historical Average Annual Historical Average Annual Returns and Return Variability: Returns and Return Variability:

1926-20011926-2001

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

GeometricMean

ArithmeticMean

StandardDeviation

Large Company Stocks

Small Company Stocks**

Long-Term CorporateBonds

Long-Term GovernmentBonds

Intermediate-TermGovernment Bonds

U.S. Treasury Bills

Inflation

Returns and Risk of Returns and Risk of Different Asset ClassesDifferent Asset Classes

Measuring risk by probability of Measuring risk by probability of notnot meeting your investment return meeting your investment return objective indicates risk of equities is objective indicates risk of equities is small and risk of T-bills is large small and risk of T-bills is large because of different expected returnsbecause of different expected returns

Focusing only on return variability Focusing only on return variability ignores reinvestment riskignores reinvestment risk

Changes in returns from year to yearChanges in returns from year to year

Asset Allocation Asset Allocation SummarySummary

Policy statement determines types of Policy statement determines types of assets to include in portfolioassets to include in portfolio

Asset allocation determines portfolio Asset allocation determines portfolio return more than stock selectionreturn more than stock selection

Over long time periods sizable Over long time periods sizable allocation to equity will improve allocation to equity will improve resultsresults

Risk of a strategy depends on the Risk of a strategy depends on the investor’s goals and time horizoninvestor’s goals and time horizon

Asset Allocation and Asset Allocation and Cultural DifferencesCultural Differences Social, political, and tax Social, political, and tax

environmentsenvironments U.S. institutional investors average U.S. institutional investors average

45% allocation in equities45% allocation in equities In the United Kingdom, equities In the United Kingdom, equities

make up 72% of assetsmake up 72% of assets In Germany, equities are 11%In Germany, equities are 11% In Japan, equities are 24% of assetsIn Japan, equities are 24% of assets

Asset Allocation StrategiesAsset Allocation Strategies Integrated asset allocationIntegrated asset allocation

capital market conditionscapital market conditions investor’s objectives and constraintsinvestor’s objectives and constraints

Strategic asset allocationStrategic asset allocation constant-mixconstant-mix

Tactical asset allocationTactical asset allocation mean reversionmean reversion inherently contrarianinherently contrarian

Insured asset allocationInsured asset allocation constant proportionconstant proportion

Asset Allocation StrategiesAsset Allocation Strategies Selecting an allocation method Selecting an allocation method

depends on: depends on: Perceptions of variability in the Perceptions of variability in the

client’s objectives and constraints client’s objectives and constraints Perceived relationship between the Perceived relationship between the

past and future capital market past and future capital market conditionsconditions

The Importance of Asset The Importance of Asset AllocationAllocation

Does Asset Allocation Policy Explain Does Asset Allocation Policy Explain 40, 90, or 100 Percent of 40, 90, or 100 Percent of Performance?Performance? Ibbotson and Kaplan Ibbotson and Kaplan FAJFAJ Jan/Feb 2000 Jan/Feb 2000

SummarySummary Develop an investment policy statementDevelop an investment policy statement

Identify investment needs, risk tolerance, Identify investment needs, risk tolerance, and familiarity with capital marketsand familiarity with capital markets

Identify objectives and constraintsIdentify objectives and constraints Investment plans are enhanced by accurate Investment plans are enhanced by accurate

formulation of a policy statementformulation of a policy statement Asset allocation determines long-run Asset allocation determines long-run

returns and riskreturns and risk Success depends on construction of the Success depends on construction of the

policy statementpolicy statement

StyleStyle Construct a portfolio to capture one or Construct a portfolio to capture one or

more of the characteristics of equity more of the characteristics of equity securitiessecurities

Small-capitalization stocks, low-P/E stocks, Small-capitalization stocks, low-P/E stocks, etc…etc…

Value stocks appear to be underpricedValue stocks appear to be underpriced price/book or price/earningsprice/book or price/earnings

Growth stocks enjoy above-average Growth stocks enjoy above-average earnings per share increasesearnings per share increases

Does Style Matter?Does Style Matter? Choice to align with investment style Choice to align with investment style

communicates information to clientscommunicates information to clients Determining style is useful in measuring Determining style is useful in measuring

performance relative to a benchmarkperformance relative to a benchmark Style identification allows an investor to Style identification allows an investor to

diversify by portfoliodiversify by portfolio Style investing allows control of the total Style investing allows control of the total

portfolio to be shared between the investment portfolio to be shared between the investment managers and a sponsormanagers and a sponsor

Determining StyleDetermining Style

Style grid: Style grid: firm sizefirm size value-growth characteristicsvalue-growth characteristics

Style analysisStyle analysis constrained least squaresconstrained least squares

Benchmark PortfoliosBenchmark Portfolios

SharpeSharpe T-bills, intermediate-term government T-bills, intermediate-term government

bonds, long-term government bonds, bonds, long-term government bonds, corporate bonds, mortgage related corporate bonds, mortgage related securities, large-capitalization value securities, large-capitalization value stocks, large-capitalization growth stocks, stocks, large-capitalization growth stocks, medium-capitalization stocks, small-medium-capitalization stocks, small-capitalization stocks, non-U.S. bonds, capitalization stocks, non-U.S. bonds, European stocks, and Japanese stocksEuropean stocks, and Japanese stocks

Benchmark PortfoliosBenchmark Portfolios

SharpeSharpe BARRABARRA

Uses portfolios formed around 13 different Uses portfolios formed around 13 different security characteristics, including variability security characteristics, including variability in markets, past firm success, firm size, in markets, past firm success, firm size, trading activity, growth orientation, earnings-trading activity, growth orientation, earnings-to-price ratio, book-to-price ratio, earnings to-price ratio, book-to-price ratio, earnings variability, financial leverage, foreign variability, financial leverage, foreign income, labor intensity, yield, and low income, labor intensity, yield, and low capitalizationcapitalization

Benchmark PortfoliosBenchmark Portfolios

SharpeSharpe BARRABARRA Ibbotson AssociatesIbbotson Associates

simplest style model uses portfolios simplest style model uses portfolios formed around five different formed around five different characteristics: cash (T-bills), large-characteristics: cash (T-bills), large-capitalization growth, small-capitalization capitalization growth, small-capitalization growth, large-capitalization value, and growth, large-capitalization value, and small-capitalization valuesmall-capitalization value

Timing Between StylesTiming Between Styles

Variations in returns Variations in returns among mutual funds among mutual funds are largely attributable are largely attributable to differences in stylesto differences in styles

Different styles tend to Different styles tend to move at different times move at different times in the business cyclein the business cycle

Value versus GrowthValue versus Growth Growth stocks will outperform Growth stocks will outperform

value stocks for a time and value stocks for a time and then the opposite occursthen the opposite occurs

Over time value stocks have Over time value stocks have offered somewhat higher offered somewhat higher returns than growth stocksreturns than growth stocks

Value versus GrowthValue versus Growth Growth-oriented investor will:Growth-oriented investor will:

focus on EPS and its economic focus on EPS and its economic determinantsdeterminants

look for companies expected to look for companies expected to have rapid EPS growthhave rapid EPS growth

assumes constant P/E ratioassumes constant P/E ratio

Value versus GrowthValue versus Growth Value-oriented investor will: Value-oriented investor will:

focus on the price componentfocus on the price component not care much about current not care much about current

earningsearnings assume the P/E ratio is below its assume the P/E ratio is below its

natural levelnatural level

Value and Growth InvestingValue and Growth Investing

Value and Growth Investing: Review Value and Growth Investing: Review and Updateand Update Chan and Lakonishok – Financial Chan and Lakonishok – Financial

Analysts Journal Jan/Feb 2004Analysts Journal Jan/Feb 2004