2 – 1
CHAPTER 2
THE ASSET ALLOCATION DECISION
I. Individual Investor Life Cycle
A. The Preliminaries
1. Insurance
a. Life Insurance – provides lump-sum benefit to the heirs upon death of the
insured person. Could provide cash value also depending on the type of plan
B. Life Cycle Investment Strategies
1. Accumulation Phase – early to middle years of working career
C. Life Cycle Investment Goals
1. Near-term, high-priority goals – shorter-term financial objectives that individuals
set to fund purchases that are personally important to them
II. The Portfolio Management Process (Exhibit 2.3)
1. Formulate a policy statement after determining the investor’s short-term and long-
term needs as well as risk tolerance
conditions and update policy statement as needed
III. The Need for a Policy Statement
The Policy Statement is a roadmap that guides the investment process. It
A. Helps investors understand their own needs, objectives, and investment constraints
2 – 2
IV. Input to the Policy Statement
A. Investment Objectives- investment goals expressed in terms of both risk and returns
1. A careful analysis of the client’s risk tolerance should precede any discussion of
return objectives (see Exhibit 2.4)
2. Return objective may be stated in terms of an absolute or relative percentage
return. It may be also be stated in terms of general goals such as:
3. Examples
a. Investment Objective: Twenty-five-year-old – Given the young age and
1. Liquidity Needs – vary between investors depending on age, employment, tax
obligations, etc.
2. Time Horizon – influences liquidity needs and risk tolerance
3. Tax Concerns
a. Capital gains or losses – taxed differently from income
b. Unrealized capital gain – reflect price appreciation of currently held assets that
have not yet been sold
4. Legal and Regulatory Factors- must be considered
5. Unique Needs and Preferences – could influence investment choice
C. Constructing the Policy Statement – a policy statement helps determine an investor’s
2 – 3
V. The Importance of Asset Allocation
A. Real Investment Returns after Taxes and Costs – taxes and inflation can significantly
lower returns
VI. Asset Allocation and Cultural Differences – asset allocations differ across countries
2 – 4
APPENDIX
Objectives and Constraints of Institutional Investors
I. Mutual Funds – pool investors funds and invest them in financial assets as per their
investment objectives
III. Endowment Funds – represent contributions made to charitable or educational
institutions
IV. Insurance Companies
1. Life Insurance Companies