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Investment Analysis and

Portfolio Management

by Frank K. Reilly & Keith C. Brown

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The Asset Allocation Decision

Individ!al Investor "ife Cy#le

$he Portfolio Management Pro#ess

$he %eed for Poli#y tatement

Constr!#ting the Poli#y tatement

$he Im'ortan#e of Asset Allo#ation

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What is Asset Allocation?

* Asset Allo#ation+ It is the 'ro#ess of de#idinghow to distrib!te an investor,s wealth among

different #o!ntries and asset #lasses for

investment '!r'oses.

* Asset Class+ It refers to the gro!' of se#!ritiesthat have similar #hara#teristi#s- attrib!tes- and

riskret!rn relationshi's.

* Investor+ /e'ending on the ty'e of investors-investment ob0e#tives and #onstraints vary

Individ!al investors

Instit!tional investors

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Individual Investor Life Cycle

* Finan#ial Plan Preliminaries "ife Ins!ran#e+ Providing death benefits and-

'ossibly- additional #ash val!es

* $erm life and whole life ins!ran#e

* 2niversal and variable life ins!ran#e

%on)life Ins!ran#e

* 3ealth ins!ran#e & /isability ins!ran#e

* A!tomobile ins!ran#e & 3omerental ins!ran#e

Cash Reserve

* $o meet emergen#y needs

* 45!al to si6 months living e6'enses

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* "ife Cy#le Phases 846hibit (.9: A##!m!lation 'hase+ 4arly to middle years of

working #areer 846hibit (.(:

Consolidation 'hase+ Past mid'oint of #areers.

4arnings greater than e6'enses

'ending;ifting 'hase+ Begins after retirement

* "ife Cy#le Investment ;oals

%ear)term- high)'riority goals

"ong)term- high)'riority goals

"ower)'riority goals

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Exhibit 2.2

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The ortfolio !ana"e#ent rocess

* Poli#y tatement 'e#ifies investment goals and a##e'table risk

levels

ho!ld be reviewed 'eriodi#ally

;!ides all investment de#isions

* t!dy C!rrent Finan#ial and 4#onomi#

#onditions and fore#ast f!t!re trends

/etermine strategies to meet goals

Re5!ires monitoring and !'dating

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* Constr!#t the Portfolio Allo#ate available f!nds to minimi>e investor,s risks

and meet investment goals

* Monitor and 2'date

4val!ate 'ortfolio 'erforman#e

Monitor investor,s needs and market #onditions

Revise 'oli#y statement as needed

Modify investment strategy a##ordingly

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9. Poli#y tatement

Fo#!s+ Investor,s short)term and long)term needs-familiarity with #a'ital market history- and e6'e#tations

(. 46amine #!rrent and 'ro0e#t finan#ial- e#onomi#-'oliti#al- and so#ial #onditions

Fo#!s+ hort)term and intermediate)term e6'e#ted#onditions to !se in #onstr!#ting a s'e#ifi# 'ortfolio

1. Im'lement the 'lan by #onstr!#ting the 'ortfolio

Fo#!s+ Meet the investor,s needs at the minim!m risklevels

7. Feedba#k loo'+ Monitor and !'date investor needs-environmental #onditions- 'ortfolio 'erforman#e

Exhibit 2.$

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The %eed &or A olicy 'tate#ent

* 2nderstand investor,s needs and arti#!laterealisti# investment ob0e#tives and #onstraints

hat are the real risks of an adverse finan#ial

o!t#ome- and what emotional rea#tions will I have

3ow knowledgeable am I abo!t investments and thefinan#ial markets

hat other #a'ital or in#ome so!r#es do I have

3ow im'ortant is this 'arti#!lar 'ortfolio to my overall

finan#ial 'osition hat- if any- legal restri#tions affe#t me

3ow wo!ld any !nanti#i'ated 'ortfolio val!e #hange

might affe#t my investment 'oli#y

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* ets standards for eval!ating 'ortfolio'erforman#e

$he statement 'rovides a #om'arison standard in

0!dging the 'erforman#e of the 'ortfolio manager.

A ben#hmark 'ortfolio or #om'arison standard is

!sed to refle#t the risk an ret!rn ob0e#tives

s'e#ified in the 'oli#y statement.

It sho!ld a#t as a starting 'oint for 'eriodi#'ortfolio review and #lient #omm!ni#ation with the

manager.

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* ther Benefits It hel's red!#es the 'ossibility of ina''ro'riate or

!nethi#al behavior on the 'art of the 'ortfolio

manager.

A #learly written 'oli#y statement will hel' #reateseamless transition from one money manager to

another witho!t #ostly delays.

It also 'rovides the framework to hel' resolve any

'otential disagreements between the #lient andthe manager.

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Constructin" the olicy 'tate#ent

* Constr!#ting the 'oli#y statement begins with a'rofile analysis of the investor,s #!rrent and

f!t!re finan#ial sit!ations and a dis#!ssion of

investment ob0e#tives and #onstraints.

* b0e#tives

Risk

Ret!rn

* Constraints "i5!idity- time hori>on- ta6 fa#tors- legal and

reg!latory #onstraints- and !ni5!e needs and

'referen#es

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Invest#ent (b)ectives

* Risk b0e#tives Risk ob0e#tive sho!ld be based on investor,s

ability to take risk and willingness to take risk.

Risk toleran#e de'ends on an investor,s #!rrent

net worth and in#ome e6'e#tations and age.

* More net worth allows more risk taking

* Do!nger 'eo'le #an take more risk

A #aref!l analysis of the #lient,s risk toleran#esho!ld 're#ede any dis#!ssion of ret!rn

ob0e#tives.

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Invest#ent (b)ectives

* Ret!rn b0e#tives $he ret!rn ob0e#tive may be stated in terms of an

absol!te or a relative 'er#entage ret!rn.

Ca'ital Preservation+ Minimi>e risk of real losses

Ca'ital A''re#iation+ ;rowth of the 'ortfolio in

real terms to meet f!t!re need

C!rrent In#ome+ Fo#!s is in generating in#ome

rather than #a'ital gains

$otal Ret!rn+ In#rease 'ortfolio val!e by #a'ital

gains and by reinvesting #!rrent in#ome with

moderate risk e6'os!re

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Invest#ent Constraints

* "i5!idity %eeds Gary between investors de'ending !'on age-

em'loyment- ta6 stat!s- et#.

Planned va#ation e6'enses and ho!se down

'ayment are some of the li5!idity needs.* $ime 3ori>ons

Infl!en#es li5!idity needs and risk toleran#e.

"onger investment hori>ons generally re5!ires

less li5!idity and more risk toleran#e.

$wo general time hori>ons are 're)retirement and

'ost)retirement 'eriods.

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* $a6 Con#erns Ca'ital gains or losses+ $a6ed differently from

in#ome

2nreali>ed #a'ital gains+ Refle#t 'ri#e

a''re#iation of #!rrently held assets that have notyet been sold

Reali>ed #a'ital gains+ hen the asset has been

sold at a 'rofit

$rade)off between ta6es and diversifi#ation+ $a6#onse5!en#es of selling #om'any sto#k for

diversifi#ation '!r'oses

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* $a6 #on#erns 8#ontin!ed: Interest on m!ni#i'al bonds e6em't from federal

in#ome ta6 and from state of iss!e

Interest on federal se#!rities e6em't from state

in#ome ta6

Contrib!tions to an IRA may 5!alify as ded!#tible

from ta6able in#ome

$a6 deferral #onsiderations

Rate)TaxMarginal-(1

YieldMunicipal

YieldTaxableEquivalent

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!ethods of Tax Deferral

* Reg!lar IRA $a6 ded!#tible $a6 on ret!rns deferred !ntil withdrawal

* Roth IRA

%ot ta6 ded!#tible $a6)free withdrawals 'ossible

* Cash Gal!e "ife Ins!ran#e F!nds a##!m!late ta6)free !ntil they are withdrawn

* $a6 heltered Ann!ities* 4m'loyer,s 7@98k: and 7@18b: Plans

$a6)deferred investments

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Le"al and *e"ulatory &actors

* "imitations or 'enalties on withdrawals* Fid!#iary res'onsibilities

$he HPr!dent Investor R!le normally a''ly

* Investment laws 'rohibit insider trading

* Instit!tional investors deserve s'e#ial

attentions sin#e legal and reg!latory fa#tors

may affe#t them 5!ite differently 8e.g. banks

vs. endowment f!nds:.

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+ni,ue %eeds and references

* Personal 'referen#es s!#h as so#ially#ons#io!s investments #o!ld infl!en#e

investment #hoi#e.

* $ime #onstraints or la#k of e6'ertise for

managing the 'ortfolio may re5!ire'rofessional management.

* "arge investment in em'loyer,s sto#k may

re5!ire #onsideration of diversifi#ation needs.* Instit!tional investors needs.

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The I#portance of Asset Allocation

* An investment strategy is based on fo!rde#isions

hat asset #lasses to #onsider for investment

hat 'oli#y weights to assign to ea#h eligible #lass

hat allo#ation ranges are allowed based on 'oli#y

weights

hat s'e#ifi# se#!rities to '!r#hase for the 'ortfolio

* A##ording to resear#h st!dies- most 8=EJ to?EJ: of the overall investment ret!rn is d!e to

the first two de#isions- not the sele#tion of

individ!al investments 8see 46hibit (.=:

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Exhibit 2.-

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* Investment Ret!rns after $a6es and Inflation

Exhibit 2.

Com'o!nded Ann!al Ret!rns+ 9?=9)(@@<

Before $a6 After $a6es After $a6es After& Inflation & Inflation Inflation

Common to#k ?.79J .

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* Ret!rns and Risks of /ifferent Asset Classes 3istori#ally- small #om'any sto#ks have generated

the highest ret!rns- so have the volatility

Inflation and ta6es have a ma0or im'a#t on ret!rns

Ret!rns on $reas!ry Bills have barely ke't 'a#ewith inflation

Meas!ring risk by the 'robability of not meeting

yo!r investment ret!rn ob0e#tive indi#ates risk of

e5!ities is small and that of $)bills is large be#a!seof their differen#es in e6'e#ted ret!rns

Fo#!sing only on ret!rn variability as a meas!re of

risk ignores reinvestment risk

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Asset Allocation 'u##ary

* Poli#y statement determines ty'es of assetsto in#l!de in 'ortfolio

* Asset allo#ation determines 'ortfolio ret!rn

more than sto#k sele#tion

* ver long time 'eriods- si>able allo#ation to

e5!ity will im'rove res!lts

* Risk of a strategy de'ends on the investor,s

goals and time hori>on

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Asset Allocation 'u##ary

* Asset Allo#ation and C!lt!ral /ifferen#es o#ial- 'oliti#al- and ta6 environments infl!en#e the

asset allo#ation de#ision

45!ity allo#ations of 2.. 'ension f!nds average

E=J In the 2nited Kingdom- e5!ities make !'

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Exhibit 2./2

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Exhibit 2./$

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The Internet Invest#ents (nline

* htt'+www.ssa.gov

* htt'+ww.ibbotson.#om

* htt'+www.mfea.#om

* htt'+InvestmenttrategiesCal#!latorsdefa!lt.as'

* htt'+www.ase#.org

* htt'+www.finan#ialengines.#om

* htt'+www.#fainstit!te.org

* htt'+www.trowe'ri#e.#om

* htt'+www.theameri#an#ollege.ed!

* htt'+www.#f'.net* htt'+www.na'fa.org

* htt'+www.f'anet.org

* htt'+www.de#isioneering.#om

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Appendix0

(b)ectives and Constraints of

Institutional Investors

* M!t!al F!nds

Pool investors f!nds and invests them in finan#ial

assets as 'er its investment ob0e#tive

* 4ndowment F!nds

$hey re'resent #ontrib!tions made to #haritable or

ed!#ational instit!tions

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* Pension F!nds

Re#eive #ontrib!tions from the firm- its em'loyees-or both and invests those f!nds

Defined 1enefit 'romise to 'ay retirees a

s'e#ifi# in#ome stream after retirement

Defined Contribution do not 'romise a set ofbenefits. 4m'loyees, retirement in#ome is not an

obligation of the firm

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* Ins!ran#e Com'anies

"ife Ins!ran#e Com'anies* earn rate in e6#ess of a#t!arial rate

* growing s!r'l!s if the s'read is 'ositive

* fid!#iary 'rin#i'les limit the risk toleran#e

* li5!idity needs have in#reased

* ta6 r!le #hanges

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* Ins!ran#e Com'anies

%onlife Ins!ran#e Com'anies

* #ash flows less 'redi#table

* fid!#iary res'onsibility to #laimants

* Risk e6'os!re low to moderate* li5!idity #on#erns d!e to !n#ertain #laim 'atterns

* reg!lation more 'ermissive

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* Banks

M!st attra#t f!nds in a #om'etitive interest rateenvironment

$ry to maintain a 'ositive differen#e between their

#ost of f!nds and their ret!rn on assets

%eed s!bstantial li5!idity to meet withdrawals andloan demands

Fa#e reg!latory #onstraints

Documents

02 Iapm9e Ppt_ch02