LESSON 4: Asset Allocation and Security Selection

I.
Asset Allocation- is the process of deciding how to distribute an investor’s wealth among different countries and asset
classes for investment purposes.
Asset Class- is composed of securities that have similar characteristics, attributes, and risk–return relationships.
Historically, the three main asset classes have been equities (stocks), fixed income (bonds), and cash equivalent or
money market instruments. Currently, most investment professionals include real estate, commodities, futures, other
financial derivatives, and even cryptocurrencies in the asset class mix.

II. Individual Investor Life Cycle

Life Insurance should be a component of any financial plan. It protects loved ones against financial hardship should
death occur before our financial goals are met. Therefore, one of the first steps in developing a financial plan is to
purchase adequate life insurance coverage. Example: Pru Life UK, Sun Life, Philam Life
Health Insurance helps to pay medical bills. Disability insurance provides continuing income should you become unable
to work. Example: Double Dragon
Automobile and home (or rental) insurance provides protection against accidents and damage to cars or residences.
Cash Reserve Emergencies- job layoffs, and unforeseen expenses happen, and good investment opportunities emerge.
A cash reserve reduces the likelihood of being forced to sell investments at inopportune times to cover unexpected
expenses. Most experts recommend a cash reserve equal to about six months’ living expenses. Examples include money
market funds and Treasury Bills (T-Bills). Calling it a “cash” reserve means the funds should be in investments you can
easily convert to cash, with little chance of loss I value, such as money market or short-term bond mutual funds.
Examples include money market funds and Treasury Bills (T-Bills)

What Is Money Market Fund?

A money market fund is a kind of mutual fund that invests in highly liquid, near-term instruments. These instruments
include cash, cash equivalent securities, and high-credit-rating, debt-based securities with a short-term maturity (such as
U.S. Securities). Money market funds are intended to offer investors high liquidity with a very low level of risk. Money
market funds are also called money market mutual funds.

What are Treasury Bills (T-Bills) and How Do They Work?

A Treasury Bill (T-Bill) is a short-term U.S. government debt obligation backed by the Treasury Department with a maturity of one
year or less. Treasury bills are usually sold in denominations of $1,000. However, some can reach a maximum denomination of
$5 million in non-competitive bids. These securities are widely regarded as low-risk and secure investments.

T-Bill Maturities
T-bills can have maturities of just a few days or up to a maximum of 52 weeks, but common maturities are four, eight,
13, 26, and 52 weeks. On average, the longer the maturity date, the higher the interest rate that the T-Bill will pay to the
investor.
 III. Investment Strategies over an Investor’s Lifetime

Accumulation Phase Individuals in the early to middle years of their working careers are in the accumulation phase,
wherein they are attempting to accumulate assets to satisfy fairly immediate needs (for example, a down payment for a
house) or longer-term goals (children’s college education, retirement). Typically, their net worth is small, and debt from
car loans or their own past college loans may be heavy. As a result of their long investment time horizon and
future earning ability, individuals in the accumulation phase are typically willing to make relatively high-risk investments
in the hopes of making above-average nominal returns over time.
Consolidation Phase
Individuals in the consolidation phase are typically past the midpoint of their careers, have paid off much or all their
outstanding debts, and perhaps have paid, or have the assets to pay, their children’s college bills. Earnings exceed
expenses, and the excess can be invested for future retirement or estate planning needs. The typical investment horizon
for this phase is still long (20 to 30 years), so moderately high-risk investments are attractive. Still, because individuals in
this phase are concerned about capital preservation, they do not want to take abnormally high risks.
Spending Phase
The spending phase typically begins when individuals retire. Living expenses are covered by Social Security income and
income from prior investments, including employer pension plans. Because their earning years have concluded
(although some retirees take part-time positions or do consulting work), they are very conscious of protecting their
capital.
Gifting Phase
The gifting phase may be concurrent with the spending phase. In this stage, individuals may believe they have sufficient
income and assets to cover their current and future expenses while maintaining a reserve for uncertainties. In such a
case, excess assets can be used to provide financial assistance to relatives or to establish charitable trusts as an
estate planning tool to minimize estate taxes.

IV. Life Cycle Investment Goals

Near-term, high-priority goals- are shorter-term financial objectives, such as funds for a house down payment, a new
car, or a vacation trip. Parents with teenage children may have a high-priority goal to accumulate funds for college
expenses. Because these goals have short time horizons, high-risk investments are not considered suitable for achieving
them.
Long-term, high-priority goals- typically include financial independence, such as the ability to retire at a certain age.
Because of their long-term nature, higher-risk investments can help meet these objectives.
Lower-priority goals- involve desirable objectives but are not critical. Examples include a new car every few years,
redecorating the home, or take a long, luxurious vacation. A well-developed policy statement considers these diverse
goals over an investor’s lifetime. The following sections detail the proce ss for constructing an investment policy,
creating a portfolio that is consistent with the investment policy, managing the portfolio, and monitoring
its performance relative to its goals and objectives over time

V. The Portfolio Management Process

The first step in the portfolio management process, as shown in Exhibit 2.3, is for the investor to construct a policy
statement that specifies the types of risks the investor is willing to take and his or her investment goals and constraints.

The investor’s needs, as reflected in the policy statement, and financial market expectations will jointly determine the
investment strategy. Economies are dynamic and are affected by numerous industry struggles, politics, changing
demographics, and social attitudes. Thus, the portfolio will require constant monitoring and updating to reflect changes
in financial market expectations.
The third step of the portfolio management process is to construct the portfolio. Given 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. This involves constructing a portfolio
that will minimize the investor’s risks while meeting the needs specified in the policy statement.
The fourth step in the portfolio management process is the continual monitoring of the investor’s needs and
capital market conditions and, when necessary, updating of the policy statement. In turn, the investment strategy is
modified. The monitoring process involves evaluating a portfolio’s performance compared to the expectations and the
requirements listed in the policy statement.

VI. The Need for a Policy Statement

Understanding and Articulating Realistic Investor Goals
One expert in the field recommends that investors should think about the following set of questions and explain their
answers as part of the process of constructing a policy statement:
1. What are the real risks of an adverse financial outcome, especially in the short run?
2. What probable emotional reactions will I have to an adverse financial outcome?
3. How knowledgeable am I about investments and financial markets?
4. What other capital or income sources do I have? How important is this particular portfolio to my overall financial
position?
5. What, if any, legal restrictions may affect my investment needs?
6. How would any unanticipated fluctuations in my portfolio value affect my investment policy?
Standards for Evaluating Portfolio Performance
A Policy Statement typically includes a benchmark portfolio, or comparison standard. Notably, both the client and the
portfolio manager must agree that the benchmark portfolio reflects the risk preferences and appropriate return
requirements of the client. The investment performance of the portfolio manager should be compared to this
benchmark portfolio.

VII. Investment Objectives

The investor’s objectives are his or her investment goals, expressed in terms of both risk and returns. (Goals should not
be expressed only in terms of returns because such an approach can led to inappropriate investment practices, such as
high-risk strategies or excessive trading.)
Capital Preservation- means that investors want to minimize their risk of loss, usually in real terms: They seek to
maintain the purchasing power of their investment. In other words, the return needs to be no less than the rate of
inflation. Generally, this is a strategy for strongly risk-averse investors or for funds needed in the short run, such as for
next year’s tuition payment or a down payment on a house.
Capital Appreciation- is an appropriate objective for investors who want the portfolio to grow in real terms over time to
meet some future need. Under this strategy, growth mainly occurs through capital gains.
When Current Income- is the return objective, investors want to generate income rather than capital gains. Retirees
may favor this objective for part of their portfolio to help generate spendable funds.
The 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. The total return strategy seeks to increase portfolio value by both capital gains and
reinvesting current income

VIII. Investment Constraints

Liquidity Needs- An asset is liquid if it can be quickly converted to cash at a price close to fair market value. Generally,
liquid assets involve many traders who are interested in a fairly standardized product. Examples include Treasury bills
that are very liquid in contrast to real estate and venture capital that are considered to be illiquid.
Tax Concerns- Investment planning is complicated by taxes that can seriously become overwhelming if international
investments are part of the portfolio. Taxable income from interest, dividends, or rents is taxable at the investor’s
marginal tax rate. The marginal tax rate is the proportion of the next one dollar in income paid as taxes.
A Note Regarding Taxes- The impact of taxes on investment strategy and final results is clearly very
significant. Unfortunately, a proper presentation on the numerous rules and regulations would be very long and
complicated. In addition, the regulations are driven by politics more than financial and economic theory and, therefore,
are constantly changing.
Legal and Regulatory Factors- Both the investment process and the financial markets are highly regulated and subject to
numerous laws. At times, these legal and regulatory factors constrain the investment strategies of individuals
and institutions.

IX. The Importance of Asset Allocation

There are four decisions involved in constructing an investment strategy:
1. What asset classes should be considered for investment?
2. What policy weights should be assigned to each eligible asset class?
3. What are the allowable allocation ranges based on policy weights?
4. What specific securities or funds should be purchased for the portfolio?
LESSON 5: Organization and Functioning of securities Markets

CHARACTERISTICS OF A GOOD MARKET

A component of liquidity is price continuity, which means that prices do not change much from one transaction to the
next unless substantial new information becomes available. In turn, a market with price continuity requires depth
wherein there are numerous potential buyers and sellers willing to trade at prices above and below the current market
price.
A good market for goods and services has the following characteristics:
1. Timely and accurate information on the price and volume of past transactions.
2. Liquidity, meaning an asset can be bought or sold quickly at a price close to the prices for previous
transactions—that is, it has price continuity, which requires depth.
3. Low transaction costs, including the cost of reaching the market, the actual brokerage costs, and the cost of
transferring the asset.
4. Prices that rapidly adjust to new information, so the prevailing price is fair since it reflects all available
information regarding the asset.

DECIMAL PRICING
Prior to the initiation of changes in late 2000 that were completed in early 2001, common stocks in the United States
were always quoted in fractions. Specifically, prior to 1997 they were quoted in eighths (e.g., 1 8 , 2 8 , , 7 8 ), with each
eighth equal to $0.125. This was modified in 1997, when the fractions for most stocks went to sixteenths (e.g., 1 16 , 2
16 , , 15 16 ), each equal to $0.0625. Now U.S. equities are priced in decimals (cents), so the minimum spread can be in
cents (e.g., $30.10 $30.12). The espoused reasons for the change to decimal pricing are threefold.
First, investors can easily understand and compare prices. Second, decimal pricing reduces the minimum variation (e.g.,
the tick size) from a minimum of 6.25 cents (when prices are quoted in sixteenths) to 1 cent (when prices are in
decimals). This allowed bid-ask spreads to fall from $0.0625 to $0.01. Third, the change made U.S. markets more
competitive on a global basis since other countries were pricing on a comparable basis. Decimalization has reduced
spread size and transaction costs, which has led to a decline in transaction size and an increase in the number of
transactions. For example, the number of transactions on the NYSE went from a daily average of 877,000 in 2000 to over
13 million during 2016, while the average trade size went from 1,187 shares in 2000 to about 250 shares in 2016.

ORGANIZATION OF THE SECURITIES MARKET

The principal distinction is between primary markets, where new securities are sold, and secondary markets, where
outstanding securities are bought and sold.
Municipal Bond Issues
New Municipal Bond Issues are sold by one of three methods: competitive bid, negotiation, or private placement.
Competitive bid sales typically involve sealed bids. The bond issue is sold to the bidding syndicate of underwriters that
submits the bid with the lowest interest cost in accordance with the stipulations set forth by the issuer. Negotiated sales
involve contractual arrangements between underwriters and issuers wherein the underwriter helps the issuer prepare
the bond issue and set the price and has the exclusive right to sell the issue. Private placements involve the sale of a
bond issue by the issuer directly to an investor or a small group of investors (usually institutions).
The underwriting function can involve three services: origination, risk-bearing, and distribution. Origination involves
the design of the bond issue and initial planning. To fulfill the risk-bearing function, the underwriter acquires the total
issue at a price dictated by the competitive bid or through negotiation and accepts the responsibility and risk of reselling
it for more than the purchase price. Distribution involves selling it to investors with the help of a selling syndicate that
includes other investment banking firms and/or commercial banks.
Corporate Bond Issues are typically sold through a negotiated arrangement with an investment banking firm that
maintains a relationship with the issuing firm. In a global capital market, there has been an explosion of new
instruments, so that designing the characteristics and currency for the security is becoming more important because the
corporate chief financial officer (CFO) may not be completely familiar with the many new instruments and the
alternative capital markets around the world.
Corporate Stock Issues- For corporations, new stock issues are typically divided into two groups: (1) seasoned equity
issues and (2) initial public offerings (IPOs).
Seasoned Equity Issues- are new shares offered by firms that already have stock outstanding. An example would be
General Electric, which is a large, well-regarded firm that has had public stock trading on the NYSE for over 50 years.
Initial public offerings (IPOs)- involve a firm selling its common stock to the public for the first time. At the time of an
IPO, there is no existing public market for the stock; that is, the company has been closely held. An example was an IPO
by Polo Ralph Lauren, a leading manufacturer and distributor of men’s clothing. The purpose of the offering was to get
additional capital to expand its operations and to create a public market for future seasoned offerings.

INTRODUCTION OF RULE 415

The typical practice of negotiated arrangements involving numerous investment banking firms in syndicates and selling
groups has changed with the introduction of Rule 415, which allows large firms to register security issues and sell them
piecemeal during the following two years. These issues are referred to as shelf registrations because, after they
are registered, the issues lie on the shelf and can be taken down and sold on short notice whenever it suits the issuing
firm. As an example, Apple Computer could register an issue of 5 million shares of common stock during 2018 and sell 1
million shares in early 2018, another million shares in late 2018, 2 million shares in early 2019, and the rest in late 2019.
Rule 144A
Rule 144A (formally 17 CFR § 230.144A) is a Securities Exchange Commission (SEC) regulation that enables purchasers
of securities in a private placement to resell their securities to qualified institutional buyers (QIBs) under certain
conditions.

Generally, under Rule 506 of Regulation D, purchasers of securities issued in a private placement may not resell their
securities. Rule 144A allows purchasers of such securities to resell those securities if: (1) the sale is to a qualified
institutional buyer (QIB); (2) the seller takes affirmative steps to ensure that the buyer is aware that the seller relies on
Rule 144A to sell their security; (3) the securities are not of the same class as securities traded on a national securities
exchange; and (4) the purchaser has the right to request information from the original issuer of the security.
Rule 144A makes issuing large quantities of securities in private placements under Rule 506 more attractive because it
increases the liquidity of those securities sold in a private placement. That is, since the institutional investors who
initially purchased the issuer’s securities in a private placement can sell to a broader group of prospective
secondary purchasers under Rule 144A, it makes private placements more attractive.
SECONDARY FINANCIAL MARKETS
Secondary markets permit trading in outstanding issues; that is, stocks or bonds already sold to the public are traded
between current and potential owners. The proceeds from a sale in the secondary market do not go to the issuing unit
(the government, municipality, or company) but rather to the current owner of the security.
Why Secondary Markets Are Important?
- Because the secondary market involves the trading of securities initially sold in the primary market, it provides liquidity
to the individuals who acquired these securities. The point is, after acquiring securities in the primary market, investors
may want to sell them again to acquire other securities, buy a house, or go on a vacation. The primary market
benefits from this liquidity because investors would hesitate to acquire securities in the primary market if they thought
they could not subsequently sell them in the secondary market. The point is, without an active secondary market, stock
or bond issuer in the primary market would have to provide a higher rate of return to compensate investors for the
substantial liquidity risk.
Secondary Bond Markets- The secondary market for bonds distinguishes among those issued by the federal
government, municipalities, or corporations. Secondary Markets for U.S. Government and Municipal Bonds U.S.
government bonds are traded by bond dealers that specialize in either Treasury bonds or agency bonds. Treasury
issues are bought or sold through a set of 35 primary dealers, including large banks in New York and Chicago and some
large investment banking firms like Goldman Sachs and Morgan Stanley. These institutions and other firms also make
markets for government agency issues, but there is no formal set of dealers for agency securities. The major market
makers in the secondary municipal bond market are banks and investment firms. Banks are active in municipal bond
trading and underwriting of general obligation bond issues since they invest heavily in these securities. Also,
many large investment firms have municipal bond departments that underwrite and trade these issues.
Secondary Equity Markets- Basic Trading Systems Although stock exchanges are similar because only qualified stocks
can be traded by individuals who are members of the exchange, they can differ in themes. There are two major
trading systems, and an exchange can use one or a combination of them. One is a pure auction market (also referred to
as an order-driven market), in which interested buyers and sellers submit bid-and-ask prices (buy and sell orders) for a
given stock to a central location where the orders are matched by a broker who does not own the stock but acts as a
facilitating agent. Participants also refer to this system as price driven because shares of stock are sold to the investor
with the highest bid price and bought from the seller with the lowest offering price. Advocates of an auction market
argue at the extreme for a very centralized market that ideally will include all the buyers and sellers of the stock.
The other major trading system is a dealer market (also referred to as a quote-driven market) where individual dealers
provide liquidity for investors by buying and selling the shares of stock for themselves. Ideally, this system involves
numerous dealers competing against each other to provide the highest bid prices when you are selling and the lowest
asking price when you are buying stock.

CALL VERSUS CONTINUOUS MARKETS

In call markets, the intent is to gather all the bids and asks for a stock at a point in time and derive a single price where
the quantity demanded is as close as possible to the quantity supplied. Call markets are generally used during the early
stages of development of an exchange when there are few stocks listed or a small number of active investor-traders. On
a call market exchange, a designated market maker would call the roll of stocks and ask for interest in one stock at a
time. After determining the available buy and sell orders, exchange officials would specify a single price that will satisfy
most of the orders, and all orders are transacted at this designated price.
In a continuous market, trades occur at any time the market is open wherein stocks are priced either by auction or by
dealers. In a dealer market, dealers are willing to buy or sell for their own account at a specified bid-and-ask price. In
an auction market, enough buyers and sellers are trading to allow the market to be continuous; that is, when one
investor comes to buy stock, there is another investor available and willing to sell stock. A compromise between a pure
dealer market and a pure auction market is a combination structure wherein the market trading system is basically an
auction market, but there exists an intermediary who is willing to act as a dealer if the pure auction market does not
have enough activity.
ALTERNATIVE TYPES OF ORDERS AVAILABLE
The most common type of order is a market order, an order to buy or sell a stock at the best current price. An investor
who enters a market sell order indicates a willingness to sell immediately at the highest bid available at the time the
order reaches a registered exchange, an ECN, or a dark pool. A market buy order indicates that the investor is willing to
pay the lowest offering price available at the time of the order. Market orders provide immediate liquidity for an
investor willing to accept the prevailing market price.
Limit Orders- The individual placing a limit order specifies the buy or sell price. You might submit a limit– order bid to
purchase 100 shares of Coca-Cola (KO) stock at $40 a share when the current market is 45 bid–45.10 ask, with the
expectation that the stock will decline to $40 soon. You must also indicate how long the limit order will be outstanding.
Alternative time specifications are basically boundless. A limit order can be instantaneous (“fill or kill,” meaning fill the
order instantly or cancel it). In the world of algorithmic trading, this is a popular time specification for high-frequency
traders. It can also be good for part of a day, a full day, several days, a week, or a month. It can also be open ended, or
good until canceled (GTC).
Special Orders- addition to these general orders, there are several special types of orders. A stop loss order is a
conditional market order whereby the investor directs the sale of a stock if it drops to a given price. Assume you buy a
stock at $50 and expect it to increase in value. If you are wrong, you want to limit your losses. To protect yourself, you
could put in a stop loss order at $45. In this case, if the stock dropped to $45, your stop loss order would become a
market sell order, and the stock would be sold at the prevailing market price. The stop loss order does not guarantee
that you will get the $45; you can get a little bit more or a little bit less. Because of the possibility of market disruption
caused by many stop loss orders, exchanges have, on occasion, canceled all such orders on certain stocks and not
allowed brokers to accept further stop loss orders on those issues.