Finance Chapter 2 Investment Objective Yearold Given The Fact That Employment Will Ceasing Soon Current

CHAPTER 2

ASSET ALLOCATION AND SECURITY SELECTION

2.1 Individual Investor Life Cycle

2.1.1 The Preliminaries

1. Insurance

▪ Life insurance – provides lump-sum benefit to the heirs upon death of the insured person.

2. Cash Reserve

2.1.2 Investment Strategies over an Investor’s Lifetime (Exhibit 2.1)

2. Consolidation Phase – past midpoint of careers. Earnings exceed expenses

4. Gifting Phase – may be concurrent with the spending phase

2.1.3 Life Cycle Investment Goals

1. Near-term, high-priority goals – shorter-term financial objectives that individuals set to

2.2 The Portfolio Management Process (Exhibit 2.3)

▪ Construct a policy statement after determining the investor’s short-term and long-term needs

2.3 The Need for a Policy Statement

2.3.1 Understanding and Articulating Realistic Investor Goals

2.3.2 Standards for Evaluating Portfolio Performance

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2.3.3 Other Benefits

▪ Protects the client against a portfolio manager’s inappropriate investments or unethical

2.4 Input to the Policy Statement

2.4.1 Investment Objectives

▪ Objectives are investment goals expressed in terms of both risk and returns.

▪ A careful analysis of the client’s risk tolerance should precede any discussion of return

objectives.

2.4.2 Investment Constraints

1. Liquidity Needs – vary between investors depending on age, employment, tax obligations,

etc.

3. Tax Concerns

4. Legal and Regulatory Factors

▪ Both the investment process and the financial markets are highly regulated and subject

5. Unique Needs and Preferences – could influence investment choice

2.5 Constructing the Policy Statement

2.5.1 General Guidelines

▪ Investors and advisors should consider the following questions:

– What are the real risks of an adverse financial outcome, especially in the short run?

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– What, if any, legal restrictions may affect my investment needs?

2.5.2 Some Common Mistakes

2.6 The Importance of Asset Allocation (Exhibits 2.4, 2.5, 2.6)

2.6.1 Investment Returns after Taxes and Costs

2.6.2 Returns and Risks of Different Asset Classes

2.6.3 Asset Allocation Summary

2.6.4 Asset Allocation and Cultural Differences

2.7 The Case for Global Investments

2.7.1 Relative Size of U.S. Financial Markets (Exhibit 2.7)

2.7.2 Rates of Return on U.S. and Foreign Securities

2. Global Bond-Market Returns (Exhibit 2.9)

2.7.3 Risk of Diversified Country Investments

1. Global Bond Portfolio Risk (Exhibits 2.10, 2.11)

3. Summary on Global Investing

▪ Market for non-U.S. bonds and stocks, and found that this market has grown in size

and importance.

2.8 Historical Risk-Returns on Alternative Investments

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2.8.1 World Portfolio Performance (Exhibit 2.14)

1. Asset Return and Total Risk

2. Return and Systematic Risk (Exhibit 2.15)

3. Correlations between Asset Returns (Exhibit 2.16)

2.8.2 Art and Antiques

▪ Study by Reilly (1992):

– Correlations among alternative antique and art categories vary substantially.

2.8.3 Real Estate (Exhibits 2.17, 2.18)

▪ Studies by Eichholtz (1996), Mull and Socnen (1997), and Quan and Titman (1997):

– Returns on real estate are equal to or slightly lower than returns on common stocks,

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APPENDIX Objectives and Constraints of Institutional Investors

I. Mutual Funds – pool investors funds and invest them in financial assets as per their

investment objectives

II. Pension Funds – receive contributions from the firms, their employees, or both and

invest those funds

III. Endowment Funds – represent contributions made to charitable or educational

institutions

IV. Insurance Companies

V. Banks – a bank’s success is primarily based on its ability to generate returns in excess

of its cost of funds