LECTURE PRESENTATION

SOFTWARE
TO ACCOMPANY
INVESTMENT ANALYSIS AND
PORTFOLIO MANAGEMENT
BY
FRANK K. REILLY & KEITH C. BROWN

Chapter 2
 CHAPTER 2
THE ASSET ALLOCATION DECISION

QUESTIONS TO BE ANSWERED:
• WHAT IS ASSET ALLOCATION?
• WHAT ARE THE FOUR STEPS IN THE PORTFOLIO MANAGEMENT
PROCESS?
• WHAT IS THE ROLE OF ASSET ALLOCATION IN INVESTMENT
PLANNING?
• WHY IS A POLICY STATEMENT IMPORTANT TO THE PLANNING
PROCESS?
 CHAPTER 2
THE ASSET ALLOCATION DECISION

• WHAT OBJECTIVES AND CONSTRAINTS SHOULD BE DETAILED IN A

POLICY STATEMENT?
• HOW AND WHY DO INVESTMENT GOALS CHANGE OVER A
PERSON’S LIFETIME AND CIRCUMSTANCES?
• WHY DO ASSET ALLOCATION STRATEGIES DIFFER ACROSS
NATIONAL BOUNDARIES?
 CHAPTER 2
THE ASSET ALLOCATION DECISION

1. Individual Investor Life Cycle

2. The Portfolio Management Process
3. The Need for a Policy Statement
4. Input to the Policy Statement
a) Investment Objectives
b) Investment Constraints
5. Constructing the Policy Statement
6. The Importance of Asset Allocation
 Definition of Asset Allocation

As risk drives return, the practice of investing funds

and managing portfolios should focus primarily on
managing risk rather than on managing returns.

Asset allocation is the process of deciding how to

distribute an investor’s wealth among different countries
and asset classes for investment purposes.

It is a component of a structured four-step portfolio

management process
 1. Individual Investor Life Cycle

Financial plans and investment needs are as

different as each individual. Investment needs
change over a person’s life cycle. How
individuals structure their financial plan should
be related to their age, financial status, future
plans, risk aversion characteristics, and needs.
1. Individual Investor Life Cycle
 Life Cycle Investment goal

Near-term, high-priority goals

Long-term, high-priority goals
Lower-priority goals
2. The Portfolio Management Process
 2. The Portfolio Management Process

Step 1: Policy Statement:

The policy statement is a road map.

All investment decisions are based on the policy
statement to ensure that these decisions are appropriate
for the investor.
 2. The Portfolio Management Process

Step 2: Investment strategy:

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 investment strategy.
 2. The Portfolio Management Process

Step 3: Portfolio Construction:

With 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.
2. The Portfolio Management Process

Step 4: Continual Monitoring:

An important component of the monitoring process

is to evaluate a portfolio’s performance and
compare the relative results to the expectations
and the requirements listed in the policy statement.
 3. The Need For A Policy Statement

A policy statement is a road map that guides the

investment process.
While it does not guarantee investment success, a
policy statement will provide discipline for the
investment process and reduce the possibility of
making hasty, inappropriate decisions.
Two Important reasons are:
It helps the investor decide on realistic investment
goals
it creates a standard by which to judge the
performance of the portfolio manager.
 4. Input To The Policy Statement

4.1 Investment Objectives:

The investor’s objectives are his or her investment

goals expressed in terms of both risk and returns.
A careful analysis of the client’s risk tolerance
should precede any discussion of return objectives. It
makes little sense for a person who is risk averse to
have his/her funds invested in high-risk assets.
Risk tolerance is more than a function of an
individual’s psychological makeup, an individual’s
family situation, his or her age, his or her current
net worth and income expectations
 4. Input To The Policy Statement

4.1 Investment Objectives:

Capital preservation means that investors want to

minimize their risk of loss, usually in real terms.
Capital appreciation is an appropriate objective when
the investors want the portfolio to grow in real terms
over time to meet some future need. Under this
strategy, growth mainly occurs through capital gains.
Current income is the return objective, the investors
want the portfolio to concentrate on generating income
rather than capital gains.
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.
 4. Input To The Policy Statement

4.1 Investment Objectives:

25-Year-Old

65-Year-Old
 4. Input To The Policy Statement

4.2 Investment Constraints

Liquidity Needs
Time Horizon
Tax Concerns
Legal and Regulatory Factors
Unique Needs and Preferences
5. Constructing The Policy Statement

The policy statement allows the investor to

communicate his or her objectives (risk and
return) and constraints (liquidity, time horizon,
tax, legal and regulatory, and unique needs and
preferences).
This communication gives the advisor a better
chance of implementing an investment strategy
that will satisfy the investor.
 6. The Importance Of Asset Allocation
About 90 percent of a fund’s returns over time can be explained by
its target asset allocation policy. (Brinson, Singer, and Beebower
(1991)

Good investment managers may add some value to portfolio

performance, but the major source of investment return—and risk—
over time is the asset allocation decision (Brown, 2000).
Investment Returns After Taxes And Inflation
Returns And Risks Of Different Asset Classes
Asset Allocation And Cultural Differences
Asset Allocation And Cultural Differences
 APPENDIX
OBJECTIVES AND CONSTRAINTS OF
INSTITUTIONAL INVESTORS

• MUTUAL FUNDS – POOL INVESTORS

FUNDS AND INVESTS THEM IN FINANCIAL
ASSETS AS PER ITS INVESTMENT OBJECTIVE
 PENSION FUNDS
• RECEIVE CONTRIBUTIONS FROM THE FIRM, ITS
EMPLOYEES, OR BOTH AND INVESTS THOSE
FUNDS
• DEFINED BENEFIT – PROMISE TO PAY RETIREES
A SPECIFIC INCOME STREAM AFTER
RETIREMENT
• DEFINED CONTRIBUTION – DO NOT PROMISE
A SET OF BENEFITS. EMPLOYEES’ RETIREMENT
INCOME IS NOT AN OBLIGATION OF THE FIRM
ENDOWMENT FUNDS
THEY REPRESENT CONTRIBUTIONS
MADE TO CHARITABLE OR
EDUCATIONAL INSTITUTIONS
 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
 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
 BANKS
• MUST ATTRACT FUNDS IN A COMPETITIVE
INTEREST RATE ENVIRONMENT
• TRY TO MAINTAIN A POSITIVE DIFFERENCE
BETWEEN THEIR COST OF FUNDS AND
THEIR RETURN ON ASSETS
• NEED SUBSTANTIAL LIQUIDITY TO MEET
WITHDRAWALS AND LOAN DEMANDS
• FACE REGULATORY CONSTRAINTS
 FUTURE TOPICS
CHAPTER 3

• INVESTMENT CHOICES
• INCLUDING GLOBAL ASSETS IN
ASSET ALLOCATION DECISIONS