Upload
hamid-ullah
View
219
Download
0
Embed Size (px)
Citation preview
8/11/2019 chapter number 2
1/44
Lecture Presentation Software to accompany
Inv es tm ent A n alys i s an dPo r t fo l io Man ag em en t
Seventh Edition
byFrank K. Reilly & Keith C. Brown
Chapter 2
8/11/2019 chapter number 2
2/44
Chapter 2The Asset Allocation Decision
Questions to be answered: What is asset allocation?
What are the four steps in the portfoliomanagement process?
What is the role of asset allocation ininvestment planning?
Why is a policy statement important tothe planning process?
8/11/2019 chapter number 2
3/44
Chapter 2The Asset Allocation Decision
What objectives and constraints shouldbe detailed in a policy statement?
How and why do investment goals changeover a persons lifetime andcircumstances?
Why do asset allocation strategies differacross national boundaries?
8/11/2019 chapter number 2
4/44
Financial Plan Preliminaries
Insurance Life insurance
Term life insurance - Provides death benefit only. Premium could changeevery renewal period
Universal and variable life insurance provide cash value plus death benefit
8/11/2019 chapter number 2
5/44
Financial Plan Preliminaries
Insurance Health insurance Disability insurance Automobile insurance
Home/rental insurance Liability insurance
8/11/2019 chapter number 2
6/44
Financial Plan Preliminaries
Cash reserve To meet emergency needs Includes cash equivalents (liquid
investments)
Equal to six months living expensesrecommended by experts
8/11/2019 chapter number 2
7/44
Individual Investor
Life Cycle Accumulation phase early to middleyears of working career
Consolidation phase past midpoint ofcareers. Earnings greater thanexpenses
Spending/Gifting phase begins afterretirement
8/11/2019 chapter number 2
8/44
Individual Investor Life Cycle
25 35 45 55 65 75
Net Worth
Age
AccumulationPhase
Long-term:Retirement
Childrenscollege
Short-term:HouseCar
Consolidation Phase
Long-term:Retirement
Short-term:
Vacations
Childrens College
Spending PhaseGifting Phase
Long-term:Estate
Planning
Short-term:Lifestyle
Needs Gifts
Exhibit 2.1
8/11/2019 chapter number 2
9/44
Life Cycle Investment Goals
Near-term, high-priority goals
Long-term, high-priority goals
Lower-priority goals
8/11/2019 chapter number 2
10/44
The Portfolio Management Process
1. Policy statement - Focus: Investors short -term and long-term needs, familiarity with capital market history, andexpectations
2. Examine current and project financial, economic, political, and social conditions - Focus: Short-term andintermediate-term expected conditions to use inconstructing a specific portfolio
3. Implement the plan by constructing the portfolio - Focus:
Meet the investors needs at the minimum risk levels
4. Feedback loop: Monitor and update investor needs,environmental conditions, portfolio performance
Exhibit 2.2
8/11/2019 chapter number 2
11/44
The Portfolio Management Process
1. Policy statement
specifies investment goals andacceptable risk levels should be reviewed periodically
guides all investment decisions
8/11/2019 chapter number 2
12/44
The Portfolio Management Process
2. Study current financial and
economic conditions and forecastfuture trends determine strategies to meet goals
requires monitoring and updating
8/11/2019 chapter number 2
13/44
The Portfolio Management Process
3. Construct the portfolio
allocate available funds to minimizeinvestors risks and meet investmentgoals
8/11/2019 chapter number 2
14/44
The Portfolio Management Process
4. Monitor and update evaluate portfolio performance Monitor investors needs and market
conditions
revise policy statement as needed modify investment strategyaccordingly
8/11/2019 chapter number 2
15/44
The Need For A Policy Statement
Helps investors understand their ownneeds, objectives, and investment
constraints Sets standards for evaluating portfolio
performance
Reduces the possibility ofinappropriate behavior on the part ofthe portfolio manager
8/11/2019 chapter number 2
16/44
Constructing A Policy Statement
Questions to be answered: What are the real risks of an adverse financial
outcome, especially in the short run? What probable emotional reactions will I have to
an adverse financial outcome?
How knowledgeable am I about investments andthe financial markets?
8/11/2019 chapter number 2
17/44
Constructing A Policy Statement
What other capital or income sources do Ihave? How important is this particular
portfolio to my overall financial position?
What, if any, legal restrictions may affectmy investment needs?
What, if any, unanticipated consequences ofinterim fluctuations in portfolio value mightaffect my investment policy?
8/11/2019 chapter number 2
18/44
Investment Objectives Risk Tolerance Absolute or relative percentage
return General goals
8/11/2019 chapter number 2
19/44
Investment ObjectivesGeneral Goals
Capital preservation
minimize risk of real loss Capital appreciation
Growth of the portfolio in real terms to meetfuture need
Current income Focus is in generating income rather than
capital gains
8/11/2019 chapter number 2
20/44
Investment Objectives
General Goals Total return
Increase portfolio value by capital gains and byreinvesting current income
Maintain moderate risk exposure
8/11/2019 chapter number 2
21/44
Investment Constraints
Liquidity needs Vary between investors depending upon age,
employment, tax status, etc. Time horizon
Influences liquidity needs and risk tolerance
8/11/2019 chapter number 2
22/44
Investment Constraints
Tax concerns Capital gains or losses taxed differently from
income Unrealized capital gain reflect price
appreciation of currently held assets that havenot yet been sold
Realized capital gain when the asset has beensold at a profit Trade-off between taxes and diversification
tax consequences of selling company stock for
diversification purposes
8/11/2019 chapter number 2
23/44
Investment Constraints
Tax concerns (continued) interest on municipal bonds exempt from
federal income tax and from state of issue interest on federal securities exempt from state
income tax contributions to an IRA may qualify as
deductible from taxable income tax deferral considerations - compounding
8/11/2019 chapter number 2
24/44
Equivalent Taxable Yield
RateTaxMarginal1YieldMunicipal
ETY
8/11/2019 chapter number 2
25/44
Effect of Tax Deferral onInvestor Wealth over Time
0 10 20 30 years
8% TaxDeferred
5.76%
After TaxReturn
$1,000
InvestmentValue
Time
$10,062.66
$5,365.91
Exhibit 2.6
8/11/2019 chapter number 2
26/44
Methods of Tax Deferral Regular IRA - tax deductible
Tax on returns deferred until withdrawal Roth IRA - not tax deductible
tax-free withdrawals possible Cash value life insurance funds accumulate tax-
free until they are withdrawn
Tax Sheltered Annuities Employers 401(k) and 403(b) plans tax-
deferred investments
8/11/2019 chapter number 2
27/44
Legal and Regulatory Factors
Limitations or penalties on withdrawals Fiduciary responsibilities -
prudent man rule Investment laws prohibit insider trading
8/11/2019 chapter number 2
28/44
Unique Needs and Preferences Personal preferences such as socially conscious
investments could influence investment choice Time constraints or lack of expertise for managing
the portfolio may require professionalmanagement
Large investment in employers stock may requireconsideration of diversification needs
Institutional investors needs
8/11/2019 chapter number 2
29/44
Constructing the Policy Statement
Objectives - risk and return Constraints - liquidity, time horizon, tax
factors, legal and regulatory constraints, andunique needs and preferences Developing a plan depends on
understanding the relationship between riskand return and the the importance ofdiversification
8/11/2019 chapter number 2
30/44
The Importance
of Asset Allocation An investment strategy is based on fourdecisions
What asset classes to consider for investment What normal or policy weights to assign to each
eligible class Determining the allowable allocation ranges
based on policy weights What specific securities to purchase for the
portfolio
8/11/2019 chapter number 2
31/44
The Importance
of Asset Allocation According to research studies, most (85% to
95%) of the overall investment return is dueto the first two decisions, not the selectionof individual investments
8/11/2019 chapter number 2
32/44
Returns and Risk of Different
Asset Classes Historically, small company stocks havegenerated the highest returns. But the
volatility of returns have been the highesttoo Inflation and taxes have a major impact on
returns Returns on Treasury Bills have barely kept pace with inflation
8/11/2019 chapter number 2
33/44
Returns and Risk of Different
Asset Classes Measuring risk by probability of not
meeting your investment return objectiveindicates risk of equities is small and thatof T-bills is large because of theirdifferences in expected returns
Focusing only on return variability as ameasure of risk ignores reinvestment risk
8/11/2019 chapter number 2
34/44
Asset Allocation Summary
Policy statement determines types of assetsto include in portfolio
Asset allocation determines portfolio returnmore than stock selection Over long time periods, sizable allocation to
equity will improve results Risk of a strategy depends on the investors
goals and time horizon
8/11/2019 chapter number 2
35/44
Asset Allocation and
Cultural Differences Social, political, and tax environments influence
the asset allocation decision
Equity allocations of U.S. pension funds average58%
In the United Kingdom, equities make up 78% ofassets
In Germany, equity allocation averages 8% In Japan, equities are 37% of assets
8/11/2019 chapter number 2
36/44
Summary
Identify investment needs, risk tolerance, andfamiliarity with capital markets
Identify objectives and constraints Enhance investment plans by accurate
formulation of a policy statement Focus on asset allocation as it determines long-
term returns and risk
8/11/2019 chapter number 2
37/44
The Internet Investments Online www.ssa.gov
www.ibbotson.com
www.mfea.com www.mfea.com/planidx.html www.asec.com www.cccsedu.org/home.html www.aimr.org
www.iafp.org
www.amercoll.edu www.idfp.org
www.napfa.org
http://www.ssa.gov/http://www.ibbotson.com/http://www.mfea.com/http://www.mfea.com/planidx.htmlhttp://www.asec.com/http://www.cccsedu.org/home.htmlhttp://www.aimr.org/http://www.iafp.org/http://www.amercoll.edu/http://www.idfp.org/http://www.napfa.org/http://www.napfa.org/http://www.idfp.org/http://www.amercoll.edu/http://www.iafp.org/http://www.aimr.org/http://www.cccsedu.org/home.htmlhttp://www.asec.com/http://www.mfea.com/planidx.htmlhttp://www.mfea.com/http://www.ibbotson.com/http://www.ssa.gov/8/11/2019 chapter number 2
38/44
Appendix
Objectives and Constraints ofInstitutional Investors
Mutual Funds pool investors funds andinvests them in financial assets as per its
investment objective
8/11/2019 chapter number 2
39/44
Pension Funds Receive contributions from the firm, its
employees, or both and invests those funds
Defined Benefit promise to pay retireesa specific income stream after retirement
Defined Contribution do not promise aset of benefits. Employees retirementincome is not an obligation of the firm
8/11/2019 chapter number 2
40/44
Endowment FundsThey represent contributions made to
charitable or educational institutions
8/11/2019 chapter number 2
41/44
Insurance Companies Life Insurance Companies
earn rate in excess of actuarial rate growing surplus if the spread is positive fiduciary principles limit the risk tolerance
liquidity needs have increased tax rule changes
8/11/2019 chapter number 2
42/44
Insurance Companies Nonlife Insurance Companies
cash flows less predictable
fiduciary responsibility to claimants Risk exposure low to moderate liquidity concerns due to uncertain claim
patterns regulation more permissive
8/11/2019 chapter number 2
43/44
Banks Must attract funds in a competitive
interest rate environment
Try to maintain a positive difference between their cost of funds and theirreturn on assets
Need substantial liquidity to meetwithdrawals and loan demands
Face regulatory constraints
8/11/2019 chapter number 2
44/44
Future topics
Chapter 3 Investment choices Including global assets in asset
allocation decisions