Get documents about "CHAPTER 20
Document Sample
CHAPTER 20
ASSET ALLOCATION
STUDENT LEANING OBJECTIVES
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?
SUGGESTIONS FOR USE AND TEACHING TIPS
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
portfolio.
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.
20-1
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.
20-2
LECTURE OUTLINE
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
20-3
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
assets
20-4
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
20-5
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?
INVESTOR PROFILE BOX – John Bogel
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?
20-6
ANSWERS TO END OF CHAPTER EXERCISES
Mini-cases
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
20-7
performance of specific stocks or bonds. Most investors form expectations
based on historical performance.
20-8
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.
20-9
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
follows:
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.
20-10
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
time.
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
suggested.
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
20-11
statement fails to provide an adequate treatment of the following key
constraints:
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
goal.
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
20-12
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
plans.
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
preferences.
20-13
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
workbook.
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.
20-14
