Chapter 21: The Investment Process (Asset Allocation)I. Why Asset Allocation?II. Individual Investor Life CycleIII. Investment ProcessChapter 21: The Investment Process (Asset Allocation)Outline:I. Why Asset Allocation?II. Individual Investor Life Cycle.III. Investment Process.Motivation:- Risk drives return. An appropriate asset allocation helps investors manage their investment risk.- Individuals’ investment objectives and attitudes toward investment risk change overtheir lifetime. Therefore, asset allocation should change over their lifetime accordingly.I. Why Asset Allocation?Asset class: a group of securities that have similar characteristics, attributes, and risk/return relationships.Asset allocation: the process of deciding how to distribute an investor’s wealth among different asset classes.There are 4 types of participants in the portfolio management process:1.Investors: they range from individual investorsto plan sponsors. They set their investment objectives. They typically assume responsibility for asset allocation. Example: UAF pension plan.2.Portfolio managers: professional managers who select securities for investors. For example, an investor may decide to put 30% of her wealth into value stocks. Then she can hire a value fund to manage the 30% of wealthin value stocks. Example: Fidelity.3.Consultants: they provide assistance on selecting portfolio managers, developing asset allocation plans, and even evaluating portfolio managers’ performance. Example: pension consultants and individual investment advisors.4.Evaluators: evaluate portfolio managers’ performance. Example: Morningstar.Asset allocation accounts for a large part of the variability (>90%) in the return on a typical institutional portfolio; security selection accounts for a trivial portion of the variability (<10%). Given the importance of asset allocation, it needs to be ensured that asset allocation plans are consistent with investors’ investment objectives.------------------------------------------------------------------------------------------------------------Annually, the Trustees of the Alaska State Pension Investment Board analyze a wide array of asset classes, examining expected returns and risk parameters. This review is necessary to ensure that the optimal combinations of investments are balanced with the Funds' long term objective of meeting future liabilities. Asset allocation is the key to portfolio management. Studies have determined that 95% of the investment return is explained by asset allocation decisions. Asset allocation helps stabilize returns because all asset classes willhave good or bad years. Diversification makes a portfolio less risky than the individual assets thatmake it up. Assets having good years can mitigate the losses of assets having bad years.The ideal asset allocation produces the best risk/return trade off. Risk is defined as the variability of returns over time. The asset allocation study identifies the most efficient mix of assets for each level of risk. This means that for each level of risk, no other mix of assets has a higher return or, for each level of return, no other mix has a lower risk. This is known most commonly as the "efficient frontier." The asset mixes on the efficient frontier represent the best diversified combinations of the asset classes considered in a particular study.------------------------------------------------------------------------------------------------------------Source: Alaska State Pension Investment BoardFor individual investors, asset allocation is complicated by the fact that individual investors’investment needs are affected by their ages,financial status, future plans, and risk aversion characteristics.CFA Which of the following statements reflects the importance of the asset allocation decision to the investment process? The asset allocation decision:a. Helps the investor decide on realistic investment goals.b. Identifies the specific securities to include in a portfolio.c. Determines most of the portfolio’s returns and volatility over time.d. Creates a standard by which to establish an appropriate investment time horizon.Answer: c.II. Individual Investor Life CycleNo serious investment plan should be started until living expenses and a safety net are covered and developed.The safety net consists of an adequate amount ofinsurance and a cash reserve (in the form of cashor short-term money instruments) equal to about six months’ living expenses.Four Investment Return Objectives:1. Capital preservation: minimize the risk of loss. Generally, this is a strategy for strongly risk-averse investors or for funds soon to be needed.2. Capital appreciation: investors want the portfolio to grow, mainly through capital gains, in real terms over time to meet some future need.3. Current income: concentrate on generating income rather than capital gains. Example: Retirees.4. Total return: investors want the portfolio to grow, through both reinvesting current income and capital gains, in real terms over time to meetsome future need. Total return’s risk exposurelies between that of the current income and capital appreciation strategies.Four Life Cycle Phases: 1. Accumulation phase: early-to-middle years of working careers. - Accumulate assets to satisfy fairly immediately needs, e.g., a down payment fora house, or longer-term goals, e.g., retirement.- Long investment horizon and strong future earning ability from their salaries means thatthey are able to make moderately high-risk investments.- Capital Appreciation and/or total return.2. Consolidation phase: past the midpoint of working careers.- Earnings exceed expenses.- The typical investment horizon is still long (20-30 years), so moderate-risk investments remain attractive.- Some concern about capital preservation.- Capital Appreciation, and/or total return, and/or capital preservation.3. Spending (4. Gifting) phase: typically begins when individuals retire.- Seek greater protection of their capital.- Still need some common stocks for inflation protection.- Plan to give excess assets away.- Current income, and/or total return, and/or capital preservation.III. Investment ProcessFour-Step Portfolio management Process:1. Construct a policy statement: specifies the types of risks investors are willing to take and their investment goals and constraints.- Possibly with the assistance of an investment advisor.- Focus: investor’s short-term and long-term