Chapter 2 The Asset Allocation Decision 1 Individual

Chapter 2 The Asset Allocation Decision 1

Individual Investor Life Cycle Exhibit 2. 1 Net Worth Accumulation Phase Consolidation Phase Spending Phase Gifting Phase Long-term: Retirement Children’s college Short-term: House Car Long-term: Retirement Short-term: Vacations Children’s College Long-term: Estate Planning Short-term: Lifestyle Needs Gifts Age 2

The Portfolio Management Process Exhibit 2. 2 1. Policy statement (road map)- Focus: Investor’s short -term and long-term needs, familiarity with capital market history, and expectations 2. Examine current and projected financial, economic, political, and social conditions - Focus: Short-term and intermediate-term expected conditions to use in constructing a specific portfolio 3. Implement the plan by constructing the portfolio Focus: Meet the investor’s needs at the minimum risk levels 4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performance 3

Input to the policy statement • Investment objectives expressed in terms of risk and return: 1. Risk Tolerance • Psychological makeup • Insurance coverage • Cash reserves • Family situation • Age • Current net worth • Income expectations 5

Investment objectives expressed in terms of risk and return: 2. Return objective – Absolute or relative percentage return – General goals 6

General Goals 1. Capital preservation – minimize risk of real loss 2. Capital appreciation – Growth of the portfolio in real terms to meet future need 7

General Goals 3. Total return – Increase portfolio value by capital gains and by reinvesting current income – Maintain moderate risk exposure 4. Income generation – Focus is in generating income rather than capital gains 8

Risk Categories and Suggested Asset Allocations for Merrill Lynch Clients Exhibit 2. 3 9

Risk Categories and Suggested Asset Allocations for Merrill Lynch Clients Exhibit 2. 3 10

How Much Risk is Right for You? Exhibit 2. 4 11

Investment Constraints 1. Liquidity needs – Vary between investors depending upon age, employment, tax status, etc. 2. Time horizon – Influences liquidity needs and risk tolerance (longer time horizon faces less liquidity and larger risk) 12

Investment Constraints 3. Tax concerns – Capital gains/losses or income distributions? – Unrealized vs realized capital gain – Trade-off between taxes and diversification (use employee payroll deduction plans or 401 k to buy company stocks) 13

Investment Constraints • Tax concerns (continued) – interest on municipal bonds exempt from federal income tax and from state of issue – interest on federal securities exempt from state income tax – contributions to an IRA may qualify as deductible from taxable income – tax deferral considerations - compounding 14

Equivalent Taxable Yield 15

Effect of Tax Deferral on Investor Wealth over Time Exhibit 2. 6 Investment Value $10, 062. 66 $5, 365. 91 $1, 000 Time 16 Marginal tax=28%, after-tax return=5. 76%=8%× (1 -28%)

Methods of Tax Deferral (for US) • Regular IRA – contributions tax deductible – Tax on returns deferred until withdrawal • Roth IRA – contributions not tax deductible – tax-free on returns possible • Cash value life insurance – funds accumulate tax-free until they are withdrawn • Tax Sheltered Annuities • Employer’s 401(k) and 403(b) plans – taxdeferred investments 17

Historical Average Annual Returns and Return Variability, 1926 -2001 Exhibit 2. 9 18

Over Long Time Periods, Equities Offer Higher Returns Exhibit 2. 10 19

Returns and Risk of Different Asset Classes • Historically, small company stocks have generated the higher returns. But the volatility of returns have been higher too. • Inflation and taxes have a major impact on returns. • Returns on Treasury Bills have barely kept pace with inflation. 20

Extra reading: Appendix of Chapter 2: Objectives and Constraints of Institutional Investors (pages 63 -66) – Mutual Funds – Pension funds – Endowment funds – Insurance companies – Banks 21