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									                                   CHAPTER 20
                                ASSET ALLOCATION


After reading Chapter 20, students should be able to answer the following questions:

1.    What is the process of building and managing an investment portfolio?
2.    How is an investment policy developed?
3.    How do capital market assumptions affect the investment process?
4.    What is asset allocation?
5.    What does monitoring a portfolio involve?


By the time you reach the final two chapters, the term is probably rapidly coming to end,
especially if you’re trying to cover the entire text. Nevertheless, we hope you can find
time in your schedule to squeeze in a couple of lectures on investment management. In
a sense everything we’ve discussed in the first 19 chapters of the text has set the stage
for these final two chapters.

The material in Chapter 20 is non-technical and has a real-world focus. Much of the
material has been presented before, going all the way back to Chapter 1. If you’re
especially pressed for time, we suggest you generally describe the process of building
and managing an investment portfolio (using Fugure 20.1 as your guide). Spend some
additional time on asset allocation and leave it at that.

On the other hand, if you have more time we suggest you cover in the chapter in depth.
Supplement the real life examples in the chapter with the Critical Thinking Exercise. We
think you’ll find students anxious to put their new found knowledge of investments to
work. Point out to students that one of the growth areas in the investments field, in
terms of employment, is in financial and investment planning for individuals.

Some other teaching tips and suggestions for Chapter 20 include:

     Make sure students understand that the process of building and managing an
      investment portfolio is not linear but rather circular. Changes in the investor’s
      circumstances or changes in capital market expectations will affect the investor’s

     It’s important for students to understand that while the overall investment process
      is essentially the same for individuals and institutions, there are many important
      differences between these two groups of investors.

   Be clear on the distinction between investment goals (or objectives) and
    investment constraints. Students should realize that in the real world, investors
    often have goals that conflict with one another, or conflict with the investor’s
    constraints. The investment advisor has to find the proper balance.

   Make sure students realize that passive and active investing are not necessarily
    mutually exclusive. Many investors mix the two approaches. For example, an
    investor might choose to index half of her portfolio (a passive approach) while
    actively managing the other half. Also, remind students that even passive
    investors need to monitor performance and make changes when appropriate.

   At the risk of sounding like a broken record, remind students while reviewing the
    historical data on capital market returns that the past is never a guarantee of the
    future. It is the fundamental conundrum of investing.

   While tax considerations are important, individual investors should never allow
    tax considerations to dominate investment decisions.


I.    Constructing and managing an investment portfolio

      A.    Investment policy

            1.     Investment objectives

            2.     Investment constraints

            3.     Preferences

      B.    Formulating financial market expectations

      C.    Portfolio construction

            1.     Strategic asset allocation

            2.     Tactical asset allocation

      D.    Portfolio monitoring

II.   Developing an investment policy

      A.    Differences between individuals and institutions

            1.     Time horizon

            2.     Changes in investor characteristics

            3.     Risk and behavior

            4.     Reasons for investing

            5.     Regulatory and legal constraints

            6.     Taxes

      B.    Formulating investment objectives

            1.     The three objectives

                   a.      Growth in capital

                   b.      Preservation of capital

                   c.      Current income

            2.     Prioritizing these objectives

             3.     Real life examples

                    a.      Mark’s retirement

                    b.      Kim’s daughter’s college education

       C.    Constraints

             1.     Definition

             2.     Time horizon

             3.     Liquidity needs

             4.     Taxes

                    a.      Capital gains are taxed at a lower rate than ordinary income

                    b.      Only realized capital gains are taxed

                    c.      Retirement plans offer substantial tax benefits

                    d.      Estate tax rates are higher than income tax rates

             5.     Regulatory and legal constraints

             6.     Special needs, circumstances and goals

III.   Financial market expectations

       A.    Macro-expectations

             1.     Based on the historical record

             2.     Stocks have outperformed bonds and cash investments by
                    substantial margins

             3.     Stock returns have exhibited much more year-to-year variability
                    than other investment returns

             4.     Much of the variability in stock returns has disappeared over longer
                    holding periods

             5.     Some observations

                    a.      Stocks are better long-term investments than other financial

                   b.         Long-term returns are far more predictable (or less
                              uncertain) than short-term returns

                   c.         The historical record is just that, a record of what happened

      B.    Micro-expectations

            1.     Definition

            2.     Based on the historical record

            3.     Micro-expectations are more difficult

IV.   Asset allocation

      A.    Types of asset allocation decisions

            1.     Strategic asset allocation

                   a.         Based on objectives, return requirements, time horizon and
                              risk preferences

                   b.         Role of macro and micro-expectations

            2.     Tactical asset allocation

            3.     Which is more important

      B.    Life cycle approach to asset allocation

      C.    Diversification and portfolio optimization

V.    Monitoring portfolios

      A.    Active versus passive management

      B.    Changes in investor circumstances

            1.     Getting older

            2.     Increases in wealth

            3.     Change in family status

      C.    Rebalancing

      D.    Performance measures and evaluation

INVESTMENT HISTORY BOX – A Brief History of Index funds

Chapter 20’s Investment History box briefly outlines the history of one today’s most
popular investment alternatives, the index fund. The concept of simply indexing an
investment portfolio was first advanced in the early 1970s. It was dismissed by most
Wall Street professionals as being both silly and heretical. But the believers in
indexing—such as John Bogel—persevered. Today, index funds represent a
substantial portion of mutual fund and pension fund assets.

Some questions to explore with your students include:

       Why did so many on Wall Street resist the notion of indexing initially, and still
        resist it today?

       Why is it difficult for many professional investors to consistently beat the market?

       Why are investors attracted to index funds?

       Index funds are most appropriate for what kinds of investors?

       Are index funds perfect investments? Do they have any drawbacks?


The Investor Profile is a brief biography about John Bogel, the innovator of index funds.
Some questions to explore his contribution are:

       What other mutual fund companies offer index funds today?

       Name several of the mutual funds and describe what index fund it follows.

INVESTMENT INSIGHT BOX – Some Suggested Retirement Portfolios

The Investment Insight box in Chapter 20 describes some suggested retirement
portfolios for investors at varying stages of their life cycles. Some questions to explore
with students includes:

       What is the major objective of each investor?

       What is the rationale behind each portfolio’s asset allocation?

       Do you agree or disagree with the suggested asset allocation? Why or why not?



This chapter has no minicases.

Review Exercises

1.    The first step is the formulation of an investment policy (a blending of objectives,
      constraints, and preferences). The second step is the formulation of capital
      market expectations (both macro and micro). The third step is asset allocation
      (strategic and tactical) and the fourth step is portfolio monitoring. The process is
      not one way; it is more of a circle.

2.    Investment policy is a set of guidelines that specify actions to be taken to achieve
      the investor’s objective, within the constraints imposed by, or on the investor.
      Some of the differences between individual and institutional investors include:
      time horizon, whether investor characteristics change, risk tolerance, reasons for
      investing, regulatory and legal constraints, and taxes.

3.    The three main investment objectives are: growth in capital, preservation of
      capital, and current income. For a young person investing for retirement the
      dominant objective is growth in capital.

4.    If Jill makes a total of 40 contributions, starting today, she will need to contribute
      about $5,135 a year in order to have $2.5 million by age 65. Reviewing the
      historical returns on financial assets, only common stocks have produced
      average returns in excess of 10 percent per year.

5.    At this point in time, John’s primary investment objective is preservation of
      capital. If he can earn a real return of 3 percent per year, John can withdraw
      approximately $122,661 per year (in constant dollars) for 25 years. Even though
      John’s primary objective is preservation of capital, growth in capital is still a
      consideration given his time horizon. Consequently, it would be a mistake to
      invest all of his funds in bonds and cash investments. Many financial planners
      would suggest the following asset allocation: 40% stocks, 30% bonds, and 30%
      cash investments.

6.    Constraints include time horizon, liquidity needs, taxes, and regulatory.
      Institutional investors are subject to more regulations than are individual
      investors. For example, institutions must follow the so-called ―prudent person‖
      rule when making investment decisions.

7.    Macro expectations concern the future performance of broad categories of
      financial assets (such as stocks and bonds). Micro expectations concern the
      future performance of narrower categories of financial assets, or even the

performance of specific stocks or bonds. Most investors form expectations
based on historical performance.

8.    Strategic asset allocation involves decisions concerning the general mix of
      assets (for example, 70 percent stocks and 30 percent bonds). Tactical asset
      allocation involves decisions concerning specific investments within each general
      category (for example, within the stock category, half invested in domestic stock
      funds and half in international stock funds. As investors move through the life
      cycle, the percentage of funds invested in stocks tends to fall while the
      percentage of funds invested in bonds and cash tends to rise.

9.    Monitoring a portfolio involves measuring its performance and assessing how
      well it is meeting investment objectives. Even a passive investor should make
      changes to the portfolio if, for example, investment objectives change.

10.   John has approximately $118,500 (75%) in stocks and $38,500 (25%) in bonds.
      To get back to his target asset allocation, John needs to decrease his stock
      holdings while increasing his bond holdings.

CFA Questions

1.   The following framework for organizing investment objectives and constraints can
     be used for most investment situations. By facilitating the identification and
     specification of the essential elements applying to a particular investor’s own
     circumstances, the framework is universal in its application. Hence, it is a
     primary and powerful tool for investment counselors, managers, and consultants.

     a.    The essential elements of an investment policy for Iva Jones are as

               Objectives

                Return: An income oriented objective is appropriate to supplement
                modest income from other sources. Some attention to inflation
                protection is important, however, because her life expectancy is 15
                years or longer.

                Risk. Capacity is somewhat below-average, given her age and other
                circumstances. A major risk is that she will outlive the ability of her
                asset base to support her needs.

               Constraints

                Time horizon: Horizon is medium-long; planning should cover at least
                a ten-year span, with annual reviews of circumstances and
                developments. Recognition of the stage of the client’s life as a limiting
                factor is important.

                Liquidity needs: Initial needs are small, given her good health and
                debt-free circumstances. A modest ―emergency fund‖ of cash
                equivalents should be sufficient unless circumstances change.

                Tax considerations: Because her income will be taxed at applicable
                rates, care must be taken to insure that any benefits or credits that
                might be available because of her, and so on are used, together with
                any appropriate portfolio-related tax minimization practices.

                Legal and regulatory requirements: As an advisor, you are acting in a
                fiduciary capacity to which the prudent person rule applies in the
                United States; no other special requirements exist.

                Unique needs, preferences, or circumstances: Nothing unusual here,
                expect that a nephew exists to whom she wants to leave her estate;
                you, as advisor, should see that she obtains competent legal advice.

     b.     The essential elements of an investment policy for the Green Foundation
            are as follows:

               Objectives

                Return: A modestly growth oriented objective consistent with a
                sustainable long run level of research spending would be appropriate
                at, say, an annual disbursement rate of 5 percent of three-year rolling
                year end portfolio market values. Such a level should permit a focus
                on production of real return to build asset value and income level over

                Risk: A virtually infinite life and a long-term investment orientation
                indicate that risk capacity is above average—how much above
                average will be determined by the attitudes and preferences of the
                investment committee.

               Constraints

                Time horizon: In the absence of any other indication, the horizon here
                is very long term; five year planning periods with annual updating are

                Liquidity needs: Although no pressing needs are identified, a liquid
                reserve equal to one year’s expected research spending would be
                desirable to preserve continuity in foundation affairs and hedge against
                unforeseen disruptions.

                Tax considerations: None. The entity is by law tax exempt.

                Legal and regulatory requirements: As a fiduciary (and in the United
                States, by law in the state in which the foundation is domiciled), you
                must comply with the prudent person rule as it applies to investment
                advisors. In addition, care must be taken to see that portfolio practice
                is consistent with the organizations tax-exempt status.

                Unique needs or circumstances: You must be aware that a very long
                horizon investment situation is involved, in which inflation protection is
                a key factor to be considered in all asset allocation decisions.

2.   The purpose of this question is to test candidates’ ability to create investment
     policies and develop investment goals.

     a.     Key constraints are important in developing a satisfactory investment plan
            in Green’s situation, as in all investment situations. In particular, those
            constraints involving investment horizon, liquidity, taxes, and unique
            circumstances are especially important to Green. His investment policy

     statement fails to provide an adequate treatment of the following key

        Horizon. At age 63 and enjoying good health, Green still has an
         intermediate to long investment horizon ahead. When considered in
         the light of his wish to pass his wealth onto his daughter and grandson,
         the horizon extends further. Despite his apparent personal orientation
         toward short term income considerations, planning should reflect a
         long term approach.

        Liquidity. With spending exceeding income and cash resources down
         to $10,000, Green is about to experience a liquidity crisis. His desire
         to maintain the present spending level requires reorganizing his
         financial situation. This may involve using some capital and
         reconfiguring his investment assets.

        Tax considerations. Green’s apparent neglect of this factor is a main
         cause of his cash squeeze and requires prompt attention as part of
         reorganizing his finances. He should get professional advice and
         adopt a specific tax strategy. In the United States, such a strategy
         should include using municipal securities and possibly other forms of
         tax shelter.

        Unique circumstances. Green’s desire to leave a $1 million estate to
         benefit his daughter and grandson is a challenge whose effects are
         primary to reorganizing his finances. Again, the need for professional
         advice to obvious. The form of the legal arrangements, for example,
         may determine the form the investments take. Green is unlikely to
         accept any investment advice that does not address this expressed

        Other constraints. Three other constraints are present. First, Green
         does not mention the need to protect himself against inflation’s effects.
         Second, he does not appear to realize the inherent contradictions
         involved in saying he needs ―a maximum return‖ with ― an income
         element large enough‖ to meet his considerable spending needs. He
         also wants ―low risk,‖ a minimum ―possibility of large losses‖ and
         preservation of the $1 million value of his investments. Third, his
         statements are unclear about whether he intends to leave $1 million or
         some larger sum that would be the inflation-adjusted future equivalent
         of today’s $1 million.

b.   Appropriate return and risk objectives for Green are as follows:

        Return. In managing Green’s portfolio, return emphasis should reflect
         his need for maximizing current income consistent with his desire to
         leave an estate at least equal to $1 million current value of his invested

    assets. Given his inability to reduce spending and his constraining tax
    situation, this may require a total return approach. To meet his
    spending needs, Green may have to supplement an insufficient yield in
    certain years with some of his investment gains. He should also
    consider inflation protection and a specific tax strategy in determining
    asset allocation. These are important needs in this situation given the
    intermediate to long investment horizon and his estate disposition

   Risk. Green does not appear to have a high tolerance for risk, as
    shown by his concern about capital preservation and the avoidance of
    large losses. Yet, he should have a moderate degree of equity
    exposure to protect his estate against inflation and to provide growth in
    income over time. A long time horizon and the size of his assets
    reflect his ability to accept such risk. He clearly needs counseling in
    this area because the current risk level is too high given his

Critical Thinking Exercise

While this exercise doesn’t require particularly difficult computer work, it is somewhat
ambiguous. Your students may need some guidance, additional information, or hints.
The exercise requires time value of money calculations. The easiest way to answer the
questions is to build a worksheet similar to the CTE, 20-1 worksheet in the Instructor

a.    Additional information students will require is the expected rate of inflation and
      the average tax rate after Scott and Shelly retire. We assumed that Scott and
      Shelly can earn a real return of 3% after they retire, meaning their annual
      retirement income (in nominal dollars) will increase at the rate of inflation. Based
      on an estimated after retirement average tax rate of 20%, Scott and Shelly will
      need to have saved almost $2.2 million by age 65.

b.    The answer appears to be no. Based on their current asset allocation, and
      average returns over the last 50 years, their portfolio will earn an annual return of
      around 8.4 percent. If inflation averages 3 percent annually, their real return will
      be 5.2 percent. At that rate of interest, the future value of their current savings,
      plus their annual contribution, equals a little less than $1.5 million (in today’s
      dollars). They will be approximately $681,000 short of their retirement goal.

c.    Scott and Shelly could increase their annual contribution, but they would have to
      save an additional $20,000 a year between now and retirement—probably not
      very practical. A more realistic approach would be to change their asset
      allocation. Their current portfolio is much too conservative given their long-term
      investment time horizon. They need more emphasis on growth in capital.

      If they cannot increase their annual contributions, the portfolio needs to earn an
      annual real return of approximately 7.35 percent. Assuming 3 percent inflation,
      the nominal return needs to be approximately 10.35 per year. Given historical
      returns on financial assets this required return suggests the following asset
      allocation: 53 percent stocks and 47 percent bonds. However, even this
      allocation may be too conservative. Most financial planners would recommend a
      minimum of 60 percent stocks and 40 percent bonds.


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