Chapter 2

The Asset Allocation Decision

Individual Investor Life Cycle

The Portfolio Management Process
The Need for Policy Statement
Constructing the Policy Statement
The Importance of Asset Allocation

What is Asset Allocation?

Asset Allocation: process of deciding how to distribute an investors wealth

among different countries and asset classes for investment purposes
Asset Class: group of securities that have similar characteristics, attributes, and
risk/return relationships
Investor: Depending on the type of investors, investment objectives and
constraints vary
o Individual investors
o Institutional investors

Individual Investor Life Cycle: Preliminaries

Life Insurance: Providing death benefits and, possibly, additional cash values
o Term life and whole life insurance
o Universal and variable life insurance
Non-life Insurance
o Health insurance & disability insurance
o Automobile insurance & Home/rental insurance
Cash Reserve
o To meet emergency needs
o Equal to six months living expenses

Phases of an Investors Life Cycle

Accumulation phase
o Early to middle years of working career
Consolidation phase
o Past midpoint of careers. Earnings greater than expenses
Spending/Gifting phase
o Begins after retirement
Life Cycle Investment Goals
Near-term, high-priority goals
Long-term, high-priority goals
Lower-priority goals
Benefits of Investing Early and Often

Portfolio Management Process: Policy Statement

Specifies investment goals and acceptable risk levels
Should be reviewed periodically
Guides all investment decisions

Need for Policy Statement

Understand investors needs and articulate realistic investment objectives and
constraints
o What are the real risks of an adverse financial outcome, and what
emotional reactions will I have?
o How knowledgeable am I about investments and the financial markets?
o What other capital or income sources do I have? How important is this
particular portfolio to my overall financial position?
o What, if any, legal restrictions affect me?
o How would any unanticipated portfolio value change might affect my
investment policy?
Sets standards for evaluating portfolio performance
o Provides a comparison standard in judging the performance of the
portfolio manager
o Benchmark portfolio or comparison standard is used to reflect the risk an
return objectives specified in the policy statement
o Should act as a starting point for periodic portfolio review and client
communication with the manager
Other Benefits
o Reduces possibility of inappropriate or unethical behaviour of the
portfolio manager
o Helps create seamless transition from one money manager to another
without costly delays
o Provides the framework to help resolve any potential disagreements
between the client and the manager
Input to the Policy Statement
Constructing the policy statement begins with a profile analysis of the
investors current and future financial situations and a discussion of investment
objectives and constraints.
Objectives
o Risk
o Return
Constraints
o Liquidity, time horizon, tax factors, legal and regulatory constraints, and
unique needs and preferences
Investment Objectives
1. Risk Objectives
Should be based on investors ability to take risk and willingness to take risk
Risk tolerance depends on an investors current net worth and income
expectations and age
o More net worth allows more risk taking
o Younger people can take more risk
Careful analysis of clients risk tolerance should precede any discussion of
return objectives
2. Return Objectives
May be stated in terms of an absolute or a relative percentage return
Capital Preservation:
o Minimize risk of real losses
Capital Appreciation: Growth of the portfolio in real terms to meet future need

Current Income: Focus is in generating income rather than capital gains

Total Return: Increase portfolio value by capital gains and by reinvesting current
income with moderate risk exposure

Investment Constraints:
1. Liquidity
Vary between investors depending upon age, employment, tax status, etc.
Planned vacation expenses and house down payment are some of the liquidity
needs.
2. Time
Influences liquidity needs and risk tolerance
Longer investment horizons generally requires less liquidity and more risk
tolerance
Two general time horizons are pre-retirement and post-retirement periods
3. Taxes and Interest Income

Interest Income: 100% of all interest income is taxed at an investors marginal

tax rate in Canada.
Assuming a marginal tax rate of 26%, an investor that receives $2,000 in
interest income will have a $520 tax liability ($2,000 X 26%)
So an investor if you received $2,000 interest income on a $100,000
investment that would be a 2% ROI on a pre-tax basis
After Tax Return on Investment (AT -ROI)
AT ROI = Pre-Tax ROI X ( 1 Marginal Tax Rate)
AT - ROI = 2% X ( 1 .26 ) = 1.48%

4. Investment Constraints: Taxes and Dividends The Dividend Tax Credit

Calculation
Dividend Income

$2,000

Div. Tax Credit Gross Up (145%)

$2,900

Fed. Tax on Grossed Up Div. (26%)

$754

($2,900 X 26%)

Fed. Div. Tax on Grossed Up Div. (18.97%)

$550 ($2,900 X
18.97%)

Net Fed. Taxes on Dividends

$204

Effective Tax Rate on Dividends

10.20% ($204
$2,000)

($754 - $550)

Assuming a marginal tax rate of 26%, the dividend tax credit effectively reduced the effective tax
rate by about 60%
5. Investment Constraints: Taxes and Capital Gains

Capital gains are also taxed at an effectively lower tax rate because only 50% of a
gain is taxed in Canada

Capital Gains Exclusion and Income Taxes

Capital Gain

$2,000

Cap. Gains Exclusion Rate (50%)

$1,000 (50% X $2,000)

Tax on Taxable Cap. Gains (26%)

$260

Effective Tax Rate on Cap. Gains

13% ($260 $2,000)

Assuming a marginal tax rate of 26%, the effective tax rate on

capital gains is 50% of the marginal rate or in this case 13%.
6. Investment Constraints: Taxes
Unrealized capital gains: Reflect price appreciation of currently held assets that
have not yet been sold
Realized capital gains: When the asset has been sold at a profit
Trade-off between taxes and diversification: Tax consequences of selling
company stock for diversification purposes
Tax Free Investments
Earn income that is NOT subject to income taxes
Tax Free Savings Accounts (TSFA)
o tax-free investments
Tax Deferred Investments
Tax deferred investments
o compound tax free but when withdrawn are subject to taxes
Registered Retirement Savings Accounts (RRSP)
o individuals can deposit money into and earned tax deferred income
At withdrawal, all funds are subject to tax
7. Legal and Regulatory Constraints
Limitations or penalties on withdrawals
Fiduciary responsibilities
o The Prudent Investor Rule normally apply
Investment laws prohibit insider trading
Institutional investors deserve special attentions since legal and regulatory
factors may affect them quite differently
o Example: banks vs. endowment funds

8. Personal Constraints: Unique Needs & Preferences

Personal preferences such as socially conscious investments could influence
investment choice
Time constraints or lack of expertise for managing the portfolio may require
professional management
Large investment in employers stock may require consideration of
diversification needs
Institutional investors needs
Importance of Asset Allocation
Asset Allocation: process of deciding how to distribute an investors wealth among
different countries and asset classes for investment purposes

An investment strategy is based on four decisions

o What asset classes to consider for investment
o What policy weights to assign to each eligible class
o What allocation ranges are allowed based on policy weights
o What specific securities to purchase for the portfolio

Importance of Asset Allocation

Importance
of Asset
Allocation

Acco
rding
to

research studies, most (85 to 95%) of the overall investment return is due to
the first two decisions, not the selection of individual investments

Historically, small company stocks have generated the highest returns, so have
the volatility
Inflation and taxes have a major impact on returns
Returns on Treasury Bills have barely kept pace with inflation

Importance of Asset Allocation

Measuring risk by the probability of not meeting your investment return

objective indicates risk of equities is small and that of T-bills is large because of
their differences in expected returns
Focusing only on return variability as a measure of risk ignores reinvestment
risk

Asset Allocation and Cultural Differences

Social, political, and tax environments influence the asset allocation decision
Equity allocations of U.S. pension funds average 58%
In the United Kingdom, equities make up 78% of assets
In Germany, equity allocation averages 8%