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Chapter 2

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Ryerson University
FIN 521
Eric Terry

Chapter 2: The Asset Allocation Decision*  The practice of investing funds and managing portfolios should focus primarily on managing risk rather than on managing returns  Asset Allocation: the process of deciding how to distribute an investor’s wealth among different countries and asset classes for investment purposes  Asset Class: comprised of securities with similar characteristics, attributes, and risk/ return relationships  Individual Investor Life Cycle: - How individuals structure their financial plans should be related to their age, financial status, future plans, risk aversion characteristics, and needs - The Preliminaries: need to make sure other needs are satisfied (must have adequate income to cover living expenses and has a safety net should the unexpected occur) o Insurance: one of the first steps in developing a financial plan is to purchase adequate life insurance  Life insurance protects loved ones against financial hardship should death occur before our financial goals are met  The death benefit paid by the insurance company can help pay medical bills and funeral expenses and provide cash that family members can use to maintain their lifestyle, retire debt, or invest for future needs (ex: children’s education, spouse retirement)  On reaching retirement age, the cash surrender value of the life insurance policy can be used for retirement or estate-planning purposes  Health insurance helps to pay additional medical bills  Disability insurance provides continuing income should you become unable to work  Automobile and home (or rental) insurances provide protection against accidents and damage to cars or residences o Cash Reserve:  Emergencies, job layoffs, and unforeseen expenses happen, and good investment opportunities emerge  It is important to have cash reserve to help meet these occasions  In addition to providing a safety cushion, a cash reserve reduces the likelihood of being forced to sell investments at inopportune times to cover unexpected expenses  Most recommend a cash reserve equal to about 6 months’ living expenses  Money market mutual funds, Canada’s Savings Bonds, and bank accounts are appropriate vehicles for cash reserve - Life-Cycle Net Worth and Investment Strategies: o Accumulation Phase: individuals in the early-to-middle years of their working careers, these individuals are attempting to accumulate assets to satisfy immediate needs (ex: down payment to a house) or longer term goals (children’s higher education, retirement)  Net worth is small  Debts from car loans or their own past student loans may be heavy  Willing to make relatively high-risk investments in the hopes of making above-average nominal returns over time o Consolidation Phase: past the midpoint of their careers, have little or no debt, and perhaps have paid, or have the assets to pay, their children’s university expenses  Earning exceeds expenses, so the excess can be invested to provide for future retirement or estate- planning needs  Typical investment phase is still long (20 to 30 years), so moderately high-risk investments are attractive  Concerned about capital preservation; they do not want to take very large risks that may put their current nest egg in jeopardy o Spending Phase: begins when individuals retire  Living expenses are covered by CPP and income from prior investments, including employer pension plans  Because their earning years have ended for the most part, they seek greater protection of their capital  Must balance their desire to preserve the nominal value of their savings due to inflation  With an annuity, the recipient receives a guaranteed, lifelong stream of income o Gifting Phase: similar to the spending phase  Individuals may believe they have sufficient income and assets to cover their current and future expenses while maintaining a reserve for uncertainties  Excess assets can be used to provide financial assistance to relatives or friends, to establish charitable trusts, or to fund trusts as an estate-planning tool to minimize estate taxes - Life-Cycle Investment Goals: o Near-term, high priority goals: shorter financial objectives that individuals set to fund purchases that are personally important to them, such as accumulating funds to make a house down payment, buy a new car, or take a trip o Long-term, high priority goals: typically include some form of financial independence, such as the ability to retire at a certain age. Because of their long-term nature, higher risk investments can be used to help meet these objectives o Lower priority goals: are just that- it might be nice to meet these objectives, but it is not critical  The Portfolio Management Process: 1. Conduct a Policy Statement: is a road map; in it, investors specify the types of risks they are willing to take and their investment goals and constraints o Focus: Investor’s short term and long-term needs, familiarly with capital market history, and expectations 2. Develop an Investment Strategy: based on current financial and economic conditions and forecast future trends, alongside the investor’s policy statement o Examine current and projected financial, economic, political, and social conditions o Focus: short-term and intermediate-term expected conditions to use in constructing a specific portfolio 3. Construct the Portfolio: the advisor implements the investment strategy and determines how to allocate available funds across different countries, asset classes, and securities o Focus: Meet the investor’s needs at minimum risk levels 4. Continual Monitoring: monitor and update investor needs, environment conditions, evaluate portfolio performance  The Need for a Policy Statement: - Two important reasons for conducting a policy statement: 1. Helps the investor decide on realistic investment goals 2. It creates a standard by which to judge the portfolio manager’s performance - Encourages investors to learn about financial markets and the risks of investing - The policy statement assists in judging the performance of a portfolio manager o Performance cannot be judged without an objective standard; the policy statement provides that objective standard - The policy statement will typically include a benchmark portfolio, or comparison standard o The risk of the benchmark, and the assets included in the benchmark, should agree with the client’s risk preferences and investment needs o Both the client and portfolio manager must agree that the benchmark portfolio reflects the client’s risk preferences and appropriate return requirements o The investment performance of the portfolio manager should be compared to this benchmark - Because it sets an objective performance standard, the policy statement acts as a starting point for periodic portfolio review and client communication with managers - Questions concerning portfolio performance or the manager’s faithfulness to the policy can be addressed in the context of the written policy guidelines  Other Benefits: o Your portfolio manager could be dismissed, promoted, take a better job, leaving your portfolio under the management of someone you do not know or does not know you o To prevent costly delays during this transition, a clearly written policy statement can ensure that the new manager “hits the ground running” o Should prevent delays in monitoring and rebalancing your portfolio and help create a seamless transition from one portfolio manager to another  Input to the Policy Statement: - Investment Objectives: his or her investment goals expressed in terms of both risk and returns o Expressing goals only in terms of returns can lead to inappropriate investment practices, such as the use of high-risk investment strategies or account churning, which involves moving quickly in and out of investments in an attempt to
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