CFA Level I - Reading 49: The asset allocation desicion

There are four general steps in the portfolio management process:

1. Write a policy statement that specifies the investor’s goals and constraints. Then itemize the risks the investor is willing to take to meet these goals.
2. Develop an investment strategy designed to satisfy the investor’s policy statement based on an analysis of the current financial and economic conditions.
3. Implement the plan by constructing the portfolio, allocating the investor’s assets across countries, asset classes, and securities based on the current and future forecast of economic conditions.
4. Monitor and update the investor’s needs and market conditions. Rebalance the investor’s portfolio as needed.

The policy statement:

• Identifies needs and constraints of the investor.
• Helps investors understand the risk and costs of investing.
• Acts as a guide for the portfolio manager.
• States the performance standards and the benchmark.
• Enforces investment discipline on the client as well as the portfolio manager.

Investment objectives must be stated in terms of both risk and return.
Return objectives may be stated in absolute terms (dollar amounts) or percentages. Return considerations also cover capital preservation, capital appreciation, current income needs, and total returns.
Specifying investment goals in terms of just return may expose an investor to inappropriate, high-risk investment strategies. Also, return-only objectives can lead to unacceptable behavior on the part of investment managers, such as excessive trading to generate excessive commissions (churning).
Risk tolerance is a function of the investor’s psychological makeup and the investor’s personal factors such as age, family situation, existing wealth, insurance coverage, current cash reserves, and income.

Capital preservation is the objective of earning a return on an investment that is at least equal to the inflation rate. The concern here is the maintenance of purchasing power. To achieve this objective, the nominal rate of return must equal the inflation rate.
Capital appreciation is the objective of earning a nominal return that exceeds the rate of inflation over some period of time. Achieving this goal means that the purchasing power of the initial investment increases over time, usually through capital gains.
Current income is the objective of earning a return on an investment for the purpose of generating income. The current income objective is usually appropriate when an investor wants or needs to supplement other sources of income to meet living expenses or some other planned spending need.
Total return is the objective of having a portfolio grow in value to meet a future need through both capital gains and the reinvestment of current income. The total return objective is riskier than the income objective, but less risky than the capital appreciation objective.
  
Liquidity refers to the ability to quickly convert investments into cash at a price close to their fair market value. Liquidity from the investor’s view is the potential need for ready cash. This may necessitate selling off assets at unfavorable terms. 

Time horizon refers to the time between making an investment and needing the funds. Since losses are harder to overcome in a short time frame, investors with shorter time horizons usually prefer lower risk investments. 

Tax concerns play an important role in investment planning because after-tax returns are what investors should be concerned with. The tax code in the U.S., and most other countries, is complex. 

Legal and regulatory factors are more of a concern to institutional investors than individuals, but the investment strategies of both may be restricted due to these constraints. 

Unique needs and preferences are constraints that investors may have that address special needs or place special restrictions on investment strategies for personal or socially conscious reasons.



Several studies support the idea that approximately 90% of a portfolio’s returns can be explained by its target asset allocations. The clear implication here is that differences in returns among asset classes are much more important in determining overall portfolio returns than differences in return due to which specific securities are selected within each asset class. For actively managed funds, actual portfolio returns are slightly less than those that would have been achieved if the manager strictly maintained the target asset allocation. This illustrates the real difficulty of improving returns by varying from target allocations (market timing) as well as of selecting undervalued securities in very efficiently priced markets.
Average asset allocations across countries differ for reasons related to demographics, social factors, legal constraints, and taxation.


One of the first steps in developing a financial plan is to purchase adequate life insurance coverage.

Most experts recommend a cash reserve equal to about six months' living expenses.



Life Cycle:
1. Accumulation Phase: Individuals in the early-to-middle years of their working careers are in the accumulation phase. These individuals are attempting to accumulate assets to satisfy fairly immediate needs (e.g. down payment for a house) or long term goals (children's education, retirement). These individuals are willing to make relatively high-risk investments in the hopes of making above-average nominal returns over time.

We must emphasize the wisdom of investing early and regularly in one's life.

2. Consolidation phase: Individuals are typically past the midpoint of their careers, have paid off much or all of their outstanding debts, and perhaps have paid, or have the assets to pay, their children's college bills. Earnings exceed expenses. The typical investment horizon is still long (20-30 years), so moderately high risk investments are attractive. At the same time, because individuals in this phase are concerned about capital preservation, they do not want to take very large risks that may put their current nest egg in jeopardy.

3. Spending phase: it begins when individuals retire. Living expenses are covered by social security income and income from prior investments, including employer pension plans. They seek greater protection of their capital, at the same time, they must balance their desire to preserve the nominal value of their savings with the need to protect themselves against a decline in the real value of their savings due to inflation.

Their overall portfolio maybe less risky than in the consolidation phase, they still need some risky growth investments (e.g. common stocks) for inflation protection.

A bear market early in our retirement can greatly reduce our accumulated funds. Annuity could be used to transfer risk from the individual to the annuity firm.

4. Gifting phase: It is similar to, and may be concurrent with, the spending phase. Individuals believe they have sufficient income and assets to cover their current and future expenses while maintaining a reserve for uncertainties. excess assets can be used to provide financial assistance to relatives or friends, to establish charitable trusts, or to fund trusts as an estate planning tool to minimize estate taxes.