The Asset Allocation Decision

Basic questions to answer-

 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
Asset allocation is the process of deciding how to
distribute an investor’s fund among asset classes for
investment purposes.
Most importantly the first step in this process is to
develop an investment policy statement or plan that
will guide all future decisions. The policy statement
includes the investor’s goals or objectives, constraints,
and investment guidelines.
 Asset Allocation

Asset Class-Composition of securities that have similar

characteristics, attributes, and risks/return
relationships
Types of Asset Class
Broad Class-Having similar features but not traceable
directly. Like Securities
Small/Specific Asset class-Directly traceable; like
common stock, Preferred stock, Junk bond, zero
coupon bond etc.
The bottom line is that, in the long run the
highest compound returns will most likely to
occur to those investors with larger exposures to
risky assets.
As we know that there are no shortcuts or
guarantees to investment success, maintaining a
reasonable and disciplined approach to
investing will increase the likelihood of
investment success over time.
 Individual Investor Life Cycle
Financial Plan:
A financial plan is a comprehensive evaluation of
an investor's current and future financial state by
using currently known variables to predict future
cash flows, asset values and withdrawal plans.
Financial plans should also be fluid, with
occasional updates when financial changes occur.
Investment Needs:
Based on financial plan investment needs
change over a person’s life cycle. Financial
plan should be structured based on the
individual investor’s age, financial status,
future plans, risk aversion characteristics and
needs.
 Individual Investor Life Cycle:

The Preliminaries
Before working on an investment program,
we need to make sure other needs are
satisfied over an Investor’s life cycle. No
serious investment plan should be started
until a potential investor has adequate
income to cover living expenses and has a
safety net to cover contingencies.
Insurance
Life Insurance:
Life insurance should be a component of any financial plan.
It provides Protection against:
 financial hardship to the family dependents due to death
of the insured.
 Life insurance also covers future uncertainties as it pays a fixed amount at
maturity disregarding whether insured is died or not.
Heath Insurance:
 It provides protections against illness to pay medical treatment expenses.
 In case of disability insured can get continuous cash benefits throughout
the life
Types of Life Insurance
• Term life and whole life insurance
• Variable life insurance-i.e. Travel insurance
Non-life Insurance
• Automobile insurance
• Property insurance
Cash reserve
To meet emergency needs
 Temporary Job layoff-COVID-19
 Due to any other unforeseen events
 To avail good investment opportunities
 Helps avoid unexpected forced sale of existing
investment at low price.
Most experts recommend a cash reserve equal
to 6-months living expenses. But this cash
reserve does not mean the funds should be in
cash form. Rather, it should be kept in short-
term income generating projects that can be
converted into cash easily without loosing the
value-like, Short-term Treasury Bills, Bank
deposits etc.
Phases of an Investor’s Life Cycle
Once it is confirmed that the basic insurance and
cash reserves needs are met, individuals can
start a serious investment program with their
savings.
Because of changes in their net worth and risk
tolerance, individuals’ investment strategies will
change over their lifetime.
Accumulation phase
– Early to middle years of working career
– Immediate needs are supposed to be satisfied, like down
payment of house or car loans
– Net worth is small, debt burden could be heavy, at this
stage individuals are willing to take relatively high-risk
investment attempting to make more than average
nominal rate of return.
– Investment at this stage with returns compounding over
time, will reap financial benefits during later phases thus
meeting long-term investment goals.
Consolidation phase
– Past midpoint of careers.
– Earnings greater than to pay their family and other expenses
– Most debts are supposed to be paid off
– Capability to save more
– Long term investment goals could be still preferred
– Willing to take moderately high risk as they have surplus money
over their expenditures.
– But still individuals are concerned about capital preservation and do
not want to take very large risks that may cause their current
smooth life in dangers.
Spending phase
– Begins after retirement
– Living expenses are covered by pension, retirement benefits and
earnings from previous investments.
– Conservative approach to be followed willing to capital preservation.
– Risk tolerance is limited
– They must balance their desire to preserve the nominal value of their
savings with the need to protect themselves against a decline in the
real value of savings due to inflation.
– Suitable for 60 years and above aged people
– Spending tendency declines with the fear of losing previous savings.
Gifting phase
It may be similar to spending phase. At this stage, If
the individuals think they have sufficient funds or
income to cover current and near future expenses
while maintaining a reserve for uncertainties, they
can use excess money to provide financial assistance
to their relatives, friends or other distressed people.
Desires & constraints will change as one moves through the
different stages. And of course life cycle pattern also might
vary from one society to another.
 Life Cycle Investment Goals

• Near term, high priority goals, These are

shorter-term financial objectives include:
– House/Car loan monthly installment
– Take a trip
– Child education expenses
Due to their short-term nature of these goals high-
risk investments are not usually considered
suitable.
• Long term, high priority goals, aiming at to achieve
some short of financial independence, that includes
– Ability to retire at a certain age
– Lead a comfortable and stable life
High-Risk investment strategy could be used to help meet these
objectives.
• Low priority goals, just that, it might be nice to meet but
not highly required, includes
– New car at regular interval
– Redecorate the house with expensive furnishinings, luxurious
vacations etc.
 The Portfolio Mgt Process
The process of managing an investment portfolio
that never ends. Once an investment is made
according to the plan, the real work begins in
continually monitoring and updating the status of the
portfolio and investor’s needs.
 Steps in the Process

Step-1; Policy Statement

An investment policy statement (IPS) is a document
drafted between a portfolio manager and a client that
outlines general rules for the manager.
This statement provides the general investment goals
and objectives of a client and describes the strategies
that the manager should employ to achieve these
objectives
It is considered as the road map to achieve investors’
objectives.
Focus points-
i. Investors’ short & long-term needs
ii. Familiarity with the capital market history
iii. Expectations
Step-2; Examine current & projected Conditions,
i. Economic
ii. Financial
iii. Political, and
iv. Social
These would help forecasting future trends.
Here, the portfolio manager will require constant monitoring
and updating to reflect changes In financial market expectations.
Focus points-Short term & intermediate term
expected conditions to use them in
constructing a specific portfolio.
Step-3; Implement the plan by
constructing a specific portfolio
Focus point;
i. Allocate the available funds across different
assets classes.
ii. Meet the investors’ needs at minimum risk
levels specified in policy statement.
Step-4; Feedback –Actual VS Expectation
Focus points-Monitor and update investors’
needs, environmental conditions, and
evaluate portfolio performance.
 Needs for a Policy statement
A policy statement provides a discipline for the
investment process and reduce the possibility
of making hasty, inappropriate decisions.
Reasons for constructing the policy statement-
1. It helps understand and articulate realistic
investment goals: “To earn lots of money” is a
vague statement.
Policy Statement helps investors :
• Understanding their own needs, objectives,
and investment constraints
• Understand the financial market and risks,
there is always a strong relationship between
risk & return
2. It creates a standard to judge the
performance of the portfolio manager:
Performance can’t be compared without an
objective standard which is stated in policy
statement. Standard of performance of low
risk averse investor will be different from the
standard of a risky investor.
It provides benchmark portfolio.
Low-risk benchmark portfolio VS high-risk
benchmark portfolio
The risk of the benchmark and the assets
included in the benchmark, should agree with
the client’s risk preferences and investment
needs.
In turn, the investment performance of the
portfolio manager should be compared to this
benchmark portfolio being agreed between the
portfolio manager and the client.
For example-an investor seeking high-risk, high-
return investment should compare against a
high-risk benchmark portfolio.
Portfolio manager can’t be blamed just
because a risky portfolio has earned a
higher return than that of low risky portfolio
which was constructed for a risk averse
investor.
3. Other benefits-Helps protect portfolio
manager’s inappropriate investment or
unethical behavior.
A clear and unambiguous writing policy
statement reduces the possibility of portfolio
manager’s undue behaviors.
For example, portfolio manager may try to earn
a quick return from a high-risk investment
which may cause big financial loss.
 An Appropriate Statement should
satisfactorily answer the following questions
1. Is the policy statement carefully designed to
meet the needs and objectives of the investor?
2. Is the policy written so clearly that a competent
stranger could use it to manage the portfolio?
3. Would the portfolio manager has been able to
remain committed to polices during the market
experiences? That means: Does the client fully
understand investment risks?
4. Would the portfolio manager has been able
to maintain the policies specified over the
period.
5. Would the policy, if implemented, have
achieved the client’s objectives?
 Input to the Policy Statement
Investment Objectives
Expressed in terms of risk & return. There is
always a positive relationship between risk &
return.
Focus points;
 Return expectations
 Risk tolerance-This depends upon factors, like;
i. Investors current insurance coverage
ii. Cash reserves
iii. Family status-
• Marital status
• No of dependents
• Age-Old VS Young
• Level of income-high income drives towards
taking high risk in general
iv. Capital preservation-minimize risk
v. Capital appreciation(C.G)-Accept maximum risk
vi. Current income-To meet regular expenses
Investment objectives-25-year old
• Willing to take moderate or high risk as income will grow
over time.
• Long term aspect would get priority.
• Total income or capital appreciation would be right
strategy.
Investment objectives-65-year old
• Usually to be risk averse compare to 25-year
old.
• Capital preservation would be the primary
strategy.
• Current income generating portfolio would be
preferred.
• Look for a strategy that combines both current
income as well as capital preservation.
Investment Constraints
i. Liquidity Needs-Treasury bills are much
liquid than real estate and venture capital.
Focus points;
Primary goal-long term
Near term goals-require regular income
There could be for the wealthy investors who have
got fixed obligations like taxes.
25-year old investor will have less liquidity
preference compare to 65-year old investor if
situations remain normal.
Situations might change if 25-year investor has
fixed obligations like installment payment for
car or apartment or something like this.
ii. Time Horizon
Long horizon
• Investors with long investments horizons generally require
less liquidity.
• Can tolerate high portfolio risk
• 25-year would be the preferred age group
Short Horizon
• Investors with short horizon generally require more liquidity.
• Can’t tolerate high portfolio risk
• 65-year would be the preferred age group
iii. Tax Concerns
Rate of tax depends on taxable income of the
investor.
High income group-under high tax bracket
tend to prefer non-cash long term investment
Low income group-Would prefer high current
income generating portfolio as their tax rate is
low.
 Tax on capital gain is only payable when its is sold
and realized.
Capital appreciation but not realized by selling
securities would be the right strategy for high
income group.
iv. Legal & Regulatory Factors
• Penalty for unauthorized withdrawal on certain
investment in savings plan
• Fiduciary/trustee role-must make investment in
accordance with the owner’s choice.
 • Margin rule; Set by SEC
• Insider trading prohibition-Fund managers have fiduciary
duty to their shareholders. They can’t take undue
advantage of the inside information available to them for
their personal benefits.
v. Unique Needs & Preferences
• Investors may have restrictions on investing certain asset
categories. In BD like Z category share.
• Time & expertise; Busy executives prefer non-working
hours to follow up whereas retiree has time but may lack
expertise to choose and monitor.
vi. Constructing the Policy Statement
This allows the investor to determine what
factors are personally important for the
investors objectives. It works as a media to
communicate the requirements of individual
investors to the portfolio manager.
Importance of Asset Allocation
Asset allocation is a critical component of the
portfolio management process. Generally four
decisions are made when constructing an
investment strategy;
1. What assets class should be considered for
investment?
2. What policy weights to 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 portfolio?