1. Chapter 5
INVESTMENT POLICY
STATEMENTS AND ASSET
ALLOCATION ISSUES

2. Chapter 5 Questions
• What is asset allocation?
• What are four basic risk management
strategies?
• How and why do investment goals
change over a person’s lifetime and
circumstances?
• What are the four steps in the portfolio
management process?

3. Chapter 5 Questions
• Why is a policy statement important to the
planning process?
• What objectives and constraints should be
detailed in the policy statement?
• Why is investment education necessary?
• What is the role of asset allocation in
investment planning?
• Why do asset allocation strategies differ
across national boundaries?

4. What is asset allocation?
• The process of deciding
how to distribute wealth
among asset classes,
sectors, and countries
for investment
purposes.
• Not an isolated choice,
but rather a component
of the portfolio
management process.

5. Managing Risk
Since risk drives
expected return,
investing involves
managing risk rather
than managing
return.

6. Risk Management Strategies
• Risk Avoidance
– Can avoid any real chances of loss
– Generally a poor strategy except for a part
of an overall portfolio
• Risk Anticipation
– Position part of your portfolio to protect
against anticipated risk factors
– For example, maintain a cash reserve

7. Risk Management Strategies
• Risk Transfer
– Insurance and other investment vehicles can
allow for the transfer of risk, often at a price, to
another investor who is willing to bear the risk
• Risk Reduction
– Effective diversification and asset allocation
strategies can reduce risk, sometimes without
sacrificing expected return.

8. Individual Investor Life Cycle
The individual investors life cycle can
often be described using four separate
phases or stages:
• Accumulation Phase
• Consolidation Phase
• Spending Phase
• Gifting Phase

9. Accumulation Phase
• Early to middle years of careers
• Attempting to satisfy intermediate and long-
term goals
• Net worth is usually small, debt may be
heavy
• Long-term investment horizon means usually
willing to take moderately high risks in order
to make above-average returns

10. Consolidation Phase
• Past career midpoint
• Have paid off much of their
accumulated debt
• Earnings now exceed living expenses,
so the balance can be invested
• Time horizon is still long-term, so
moderately high risk investments are
still attractive

11. Spending Phase
• Usually begins at retirement
• Saving before, prudent spending now
• Living expenses covered by Social
Security and retirement plans
• Changing emphasis toward
preservation of capital, but still want
investment values to keep pace with
inflation

12. Gifting Phase
• Can be concurrent with spending phase
• If resources allow, individuals can now
use excess assets to provide gifts to
other individuals or organizations
• Estate planning becomes important,
especially tax considerations

13. The Portfolio Management
Process
A four step process:
1. Construct a policy statement
2. Study current financial conditions and
forecast future trends
3. Construct a portfolio
4. Monitor needs and conditions

14. The Portfolio Management
Process
1. Policy statement
– Specifies investment goals and acceptable
risk levels
– The “road map” that guides all investment
decisions

15. The Portfolio Management
Process
2. Study current financial and economic
conditions and forecast future trends
– Determine strategies that should meet
goals within the expected environment
– Requires monitoring and updates since
financial markets are ever-changing

16. The Portfolio Management
Process
3. Construct the portfolio
– Given the policy statement and the
expected conditions, go about investing
– Allocate available funds to meet goals
while managing risk

17. The Portfolio Management
Process
4. Monitor and update
– Revise policy statement as needed
– Monitor changing financial and economic
conditions
– Evaluate portfolio performance
– Modify portfolio investments accordingly

18. The Policy Statement
• Understand and articulate realistic goals
– Know yourself
– Know the risks and potential rewards from
investments
• Learn about standards for evaluating portfolio
performance
– Know how to judge average performance
– Adjust for risk

19. The Policy Statement
• Don’t try to navigate
without a map!
• Important Inputs:
– Investment
Objectives
– Investment
Constraints

20. Investment Objectives
Need to specify return
and risk objectives
– Need to consider the
risk tolerance of the
investor
– Return goals need to
be consistent with
risk tolerance
– These will change
over time

21. Investment Objectives
Possible broad goals:
• Capital preservation
– Maintain purchasing power
– Minimize the risk of loss
• Capital appreciation
– Achieve portfolio growth through capital
gains
– Accept greater risk

22. Investment Objectives
• Current income
– Look to generate income rather than capital gains
– May be preferred in “spending phase”
– Relatively low risk
• Total return
– Combining income returns and reinvestment with
capital gains
– Moderate risk

23. Investment Constraints
These factors may limit or at least impact the
investment choices:
• Liquidity needs
– How soon will the money be needed?
• Time horizon
– How able is the investor to ride out several bad
years?
• Legal and Regulatory Factors
– Legal restrictions often constrain decisions
– Retirement regulations

24. Investment Constraints
• Tax Concerns
– Realized capital gains vs. Ordinary income?
– Taxable vs. Tax-exempt bonds?
– Regular IRA vs. Roth IRA?
– 401(k) and 403(b) plans
• Unique needs and preferences
– Perhaps the investor wishes to avoid types of
investments for ethical reasons

25. Investment Education
• The type of information necessary to
construct a good policy statement is neither
“common sense” or “common knowledge.”
• Many investors fail to diversify.
• Many fail to plan completely.
• Data indicates that many Americans have
greatly under-invested for the future.
• The bottom line: If you do not plan for the
future, you will likely not be prepared for it.

26. Asset Allocation Decisions
Four decisions in an investment strategy:
• What asset classes should be considered?
• What should be the normal weight for each
asset class?
• What are the allowable ranges for the
weights?
• What specific securities should be
purchased?

27. The Importance of Asset
Allocation
• The asset allocation decision (which classes
and at what weights) is very important. Using
fund data:
– About 90% of return variability over time can be
explained by asset allocation.
– About 40% of the differences between returns can
be explained by differences in asset allocation.
• Asset allocation is thus the major factor that
drives portfolio risk and return.

28. Risk/Return History and
Asset Allocation
Looking at return data on various asset classes
indicate some important factors for investors:
– Over long time horizons, stocks have always
outperformed low-risk investments.
– So the additional risk of stock investing (higher
return standard deviations) over shorter time
horizons seems to all but disappear over time.
– Need to consider real investment returns over
taxes and costs

29. Asset Allocation and Cultural
Differences
• Differences in social, political, and tax
environments influence asset allocation.
• For instance, 58% of pension fund assets are
invested in equities in the U.S.
– 78% in equities in United Kingdom, where high
average inflation impacts this choice
– 8% in equities in Germany, where generous
government pensions and greater risk aversion
seem to play a strong role