Constructing a portfolio risks and return

2
2
Investment Analysis and Portfolio
Investment Analysis and Portfolio
Management
Management
First Canadian Edition
First Canadian Edition
By Reilly, Brown, Hedges, Chang
By Reilly, Brown, Hedges, Chang

Chapter 2
The Asset Allocation Decision
•Individual Investor Life Cycle
•The Portfolio Management Process
•The Need for Policy Statement
•Constructing the Policy Statement
•The Importance of Asset Allocation
Copyright © 2010 Nelson Education Ltd. 2-2

What is Asset Allocation?
• Asset Allocation
• process of deciding how to distribute an
investor’s wealth among different
countries and asset classes for investment
purposes
• Asset Class
• group of securities that have similar
characteristics, attributes, and risk/return
relationships

What is Asset Allocation?
• Investor:
• Depending on the type of investors,
investment objectives and
constraints vary
•Individual investors
•Institutional investors

Individual Investor Life Cycle:
Preliminaries
• Life Insurance: Providing death benefits
and, possibly, additional cash values
• Term life and whole life insurance
• Universal and variable life insurance
• Non-life Insurance
• Health insurance & disability insurance
• Automobile insurance & Home/rental insurance
• Cash Reserve
• To meet emergency needs
• Equal to six months living expenses

Phases of an Investor’s Life Cycle
• Accumulation phase
• Early to middle years of working career
• Consolidation phase
• Past midpoint of careers. Earnings greater
than expenses
• Spending/Gifting phase
• Begins after retirement

Phases of an Investor’s Life Cycle

Life Cycle Investment Goals
• Near-term, high-priority goals
• Long-term, high-priority goals
• Lower-priority goals

Benefits of Investing Early and Often

Portfolio Management Process:
Policy Statement
• Specifies investment goals and acceptable
risk levels
• Should be reviewed periodically
• Guides all investment decisions

Portfolio Management Process

Need for Policy Statement
• Understand investor’s needs and articulate
realistic investment objectives and
constraints
• What are the real risks of an adverse financial outcome, and what
emotional reactions will I have?
• How knowledgeable am I about investments and the financial
markets?
• What other capital or income sources do I have? How important is
this particular portfolio to my overall financial position?
• What, if any, legal restrictions affect me?
• How would any unanticipated portfolio value change might affect
my investment policy?

Need for a Policy Statement
Copyright © 2010 Nelson Education Ltd.
• Sets standards for evaluating portfolio
performance
• Provides a comparison standard in judging the performance
of the portfolio manager
• Benchmark portfolio or comparison standard is used to
reflect the risk an return objectives specified in the policy
statement
• Should act as a starting point for periodic portfolio review
and client communication with the manager
2-13

Need for a Policy Statement
• Other Benefits
• Reduces possibility of inappropriate or unethical
behaviour of the portfolio manager
• Helps create seamless transition from one money
manager to another without costly delays
• Provides the framework to help resolve any
potential disagreements between the client and
the manager

Input to the Policy Statement
• Constructing the policy statement begins
with a profile analysis of the investor’s
current and future financial situations and a
discussion of investment objectives and
constraints.

Input to the Policy Statement
• Objectives
• Risk
• Return
• Constraints
• Liquidity, time horizon, tax factors, legal
and regulatory constraints, and unique
needs and preferences

Investment Objectives
• Risk Objectives
• Should be based on investor’s ability to
take risk and willingness to take risk

• Risk tolerance depends on an investor’s
current net worth and income expectations
and age
• More net worth allows more risk taking
• Younger people can take more risk
• Careful analysis of client’s risk tolerance
should precede any discussion of return
objectives

• Return Objectives
• May be stated in terms of an absolute or a
relative percentage return
• Capital Preservation:
• Minimize risk of real losses

• Capital Appreciation: Growth of the
portfolio in real terms to meet future need
• Current Income: Focus is in generating
income rather than capital gains
• Total Return: Increase portfolio value by
capital gains and by reinvesting current
income with moderate risk exposure

Investment Constraints:
Liquidity
• Liquidity
• Vary between investors depending upon age,
employment, tax status, etc.
• Planned vacation expenses and house down
payment are some of the liquidity needs.

• Time
• Influences liquidity needs and risk tolerance
• Longer investment horizons generally requires
less liquidity and more risk tolerance
• Two general time horizons are pre-retirement
and post-retirement periods
Time
2-22

Taxes and Interest Income
2-23

• Interest Income: 100% of all interest income is
taxed at an investor’s marginal tax rate in
Canada.
• Assuming a marginal tax rate of 26%, an investor
that receives $2,000 in interest income will have
a $520 tax liability ($2,000 X 26%)
After Tax Return on Investment (AT -ROI)
AT - ROI = Pre-tax ROI X ( 1 – Marginal Tax Rate)

• Interest Income: 100% of all interest income is
taxed at an investor’s marginal tax rate in
Canada.
• So an investor if you received $2,000 interest
income on a $100,000 investment that would be
a 2% ROI on a pre-tax basis
After Tax Return on Investment (AT -ROI)
AT – ROI = Pre-Tax ROI X ( 1 – Marginal Tax Rate)
AT - ROI = 2% X ( 1 – .26 ) = 1.48%
2-25

Taxes and Dividends
The Dividend Tax Credit Calculation
Dividend Income $2,000
Div. Tax Credit Gross Up (145%) $2,900
Fed. Tax on Grossed Up Div. (26%) $754
($2,900 X 26%)
Fed. Div. Tax on Grossed Up Div. (18.97%) $550
($2,900 X 18.97%)
Net Fed. Taxes on Dividends $204
($754 - $550)
Effective Tax Rate on Dividends 10.20%
($204 ÷ $2,000)
Assuming a marginal tax rate of 26%, the dividend tax credit
effectively reduced the effective tax rate by about 60%

Taxes and Capital Gains
• Capital gains are also taxed at an effectively lower tax rate
because only 50% of a gain is taxed in Canada
Capital Gains Exclusion and Income Taxes
Capital Gain $2,000
Cap. Gains Exclusion Rate (50%) $1,000
(50% X $2,000)
Tax on Taxable Cap. Gains (26%) $260
Effective Tax Rate on Cap. Gains 13%
($260 ÷ $2,000)
Assuming a marginal tax rate of 26%, the effective tax
rate on capital gains is 50% of the marginal rate or in this
case 13%.

Investment Constraints
• Taxes
• Unrealized capital gains: Reflect price
appreciation of currently held assets that have
not yet been sold
• Realized capital gains: When the asset has been
sold at a profit
• Trade-off between taxes and diversification: Tax
consequences of selling company stock for
diversification purposes

Tax Free Investments
• Earn income that is NOT subject to income
taxes
• Tax Free Savings Accounts (TSFA)
• tax-free investments

Tax Deferred Investments
• Tax deferred investments
• compound tax free but when withdrawn are
subject to taxes
• Registered Retirement Savings Accounts
(RRSP)
• individuals can deposit money into and earned
tax deferred income
• At withdrawal, all funds are subject to tax

Legal and Regulatory Constraints
• Limitations or penalties on withdrawals
• Fiduciary responsibilities
• The “Prudent Investor Rule” normally
apply
• Investment laws prohibit insider
trading

Legal and Regulatory Constraints
• Institutional investors deserve special
attentions since legal and regulatory
factors may affect them quite
differently
• Example: banks vs. endowment funds

Personal Constraints:
Unique Needs & Preferences
• Personal preferences such as socially
conscious investments could influence
investment choice
• Time constraints or lack of expertise
for managing the portfolio may require
professional management

Personal Constraints:
Unique Needs & Preferences
• Large investment in employer’s stock
may require consideration of
diversification needs
• Institutional investor’s needs

Importance of Asset Allocation
• Asset Allocation:
• process of deciding how to distribute an
investor’s wealth among different
countries and asset classes for investment
purposes

• An investment strategy is based on four decisions
• What asset classes to consider for investment
• What policy weights to assign to each eligible
class
• What allocation ranges are allowed based on
policy weights
• What specific securities to purchase for the
portfolio

According to research studies, most (85 to 95%) of
the overall investment return is due to the first two
decisions, not the selection of individual investments
2-38

Historically, small company stocks have
generated the highest returns, so have the
volatility
Inflation and taxes have a major impact on
returns
Returns on Treasury Bills have barely kept
pace with inflation

• Measuring risk by the probability of not meeting your investment
return objective indicates risk of equities is small and that of T-
bills is large because of their differences in expected returns
• Focusing only on return variability as a measure of risk ignores
reinvestment risk

Asset Allocation
and Cultural Differences
• Social, political, and tax environments
influence the asset allocation decision
• Equity allocations of U.S. pension funds
average 58%
• In the United Kingdom, equities make up
78% of assets
• In Germany, equity allocation averages 8%

Constructing a portfolio risks and return

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