Chapter II

Asset Allocation Decision

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Dr. Tekeste B, Department of

Accounting and Finance

Chapter outline
Asset allocation
Investors life cycle
Portfolio investment process

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Dr. Tekeste B, Department of

Accounting and Finance

Asset allocation
Asset allocation
o The process of deciding how to distribute an investors wealth
among different asset classes.
o A strategy of investing that is designed to reduce the variability
of returns by diversifying across a variety of investments or
asset classes.
Asset classes : a group of securities that have similar
characteristics, attributes, and risk/return relationships:
o Fixed income assets (Bonds)
o equity (common stocks) and
o cash equivalents (Marketable securities)
Portfolio : a mix of asset classes, e.g. 60% S & P 500 and 40%
bonds
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Dr. Tekeste B, Department of

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Cntd.
Asset allocation, not security selection and
market timing, is the primary determinant of
the variation in portfolio returns:
o >90% of the variation in portfolio returns is
accounted by asset allocation
o <10% of the variation in portfolio returns is
explained by security selection.
Proper asset allocation decision
(diversification) makes the portfolio less risky
than the individual assets that make it up.
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Dr. Tekeste B, Department of

Accounting and Finance

Reflection 1
What do you
understand
from this data?
Which asset
classes are
more riskier?
Less riskier?

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Dr. Tekeste B, Department of

Accounting and Finance

Reflection 2

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Dr. Tekeste B, Department of

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42-Year Risk/Return
Analysis
Ideal risk
and
return
zone

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Each dot= asset

class
Portfolio = a
mixture of asset
classes

Dr. Tekeste B, Department of

Accounting and Finance

Diversification

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Dr. Tekeste B, Department of

Accounting and Finance

Asset allocation
In asset allocation decisions much
emphasis is given to the correlation
among the asset classes in the portfolio.
o High correlation or low correlation?
Possible values of correlation:
1. Perfect correlation takes the value of 1
or -1
2. No correlation takes the value 0
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Dr. Tekeste B, Department of

Accounting and Finance

Illustration correlation
effect
lets imagine that we engage in a typical
asset allocation decision and invest
$20,000 divided equally between a
volatile investment (red line) that goes
up and down, say up 12 percent one
month and down 8 percent the next, and
then combine it with a steadier
investment (green line) that goes up and
down half as much (up 6 percent one
Dr. Tekeste B, Department of
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10
month and down
4 percent
the next).
Accounting
and Finance

Hypothetical example
15%

10%

5%

0%
Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

-5%

-10%

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Investment A

Investmet B

Combined investment

Dr. Tekeste B, Department of

Accounting and Finance

11

Reflection -Correlation

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Dr. Tekeste B, Department of

Accounting and Finance

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Asset allocation
Given the importance of asset allocation,
it needs to be ensured that asset
allocation plans are consistent with
investors investment objectives.
Individual investors investment needs
are affected by their ages, financial
status, future plans, and risk aversion
characteristics.

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Dr. Tekeste B, Department of

Accounting and Finance

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Refresher

In your young age

would you prefer to
invest in equities
or fixed income
assets? Why?
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Dr. Tekeste B, Department of

Accounting and Finance

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II. Individual Investor Life Cycle

Investment plan:
o living expenses are covered
o A safety net is developed.
The safety net consists of an adequate
amount of insurance and a cash reserve
(in the form of cash or short-term money
instruments) equal to about six months
living expenses.

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Contd
Four Investment Return Objectives:
1. Capital preservation (stability): minimize the risk of loss
2. Capital appreciation (growth): growth of portfolio,
mainly through capital gains, in real terms over time to
meet some future need.
3. Current income (income): periodic income, rather than
capital gains, Example: Retirees.
4. Total return: reinvesting current income and capital
gains, in real terms over time to meet some future
need.

.
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Dr. Tekeste B, Department of

Accounting and Finance

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Individual Investors
Life Cycle
Accumulation phase
Consolidation phase
Spending phase
Gifting phase

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Accounting and Finance

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Individual Investor Life

Cycle
Figure 2.1

Net Worth

Accumulation
Phase

Consolidation Phase Spending Phase

Gifting Phase
Long-term:

Long-term:
Retirement
Retirement
Short-term:
Childrens college
Vacations
Short-term:
House
Car Childrens College

Long-term:
Estate Planning
Short-term:
Lifestyle Needs
Gifts

Age
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Contd
1. Accumulation phase: early-to-middle
years of working careers.
Accumulate assets to satisfy fairly
immediately needs, e.g., a down payment
for a house, or longer-term goals, e.g.,
retirement.
Long investment horizon and strong future
earning ability from their salaries means
that they are able to make moderately highrisk investments.
Capital Appreciation and/or total return.
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Dr. Tekeste B, Department of

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Contd
2. Consolidation phase: past the midpoint
of working careers.
Earnings exceed expenses.
The typical investment horizon is still long
(20-30 years), so moderate-risk investments
remain attractive.
Some concern about capital preservation.
Capital Appreciation, and/or total return,
and/or capital preservation.

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Dr. Tekeste B, Department of

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Contd
3. Spending (4. Gifting) phase: typically
begins when individuals retire.
Seek greater protection of their capital.
Still need some common stocks for inflation
protection.
Plan to give excess assets away.
Current income, and/or total return, and/or
capital preservation.

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Dr. Tekeste B, Department of

Accounting and Finance

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III. The Portfolio Investment Process

Four-Step Portfolio management Process:

1. Construct a policy statement:
specifies the types of risks investors are
willing to take and their investment goals
and constraints.

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Dr. Tekeste B, Department of

Accounting and Finance

Contd
Policy Statement:
Provide discipline and develop realistic
goals.

helps the investor to specify realistic goals and

become more informed about the risks and costs of
investing

Create a benchmark by which to judge the

performance of the portfolio manager.
Helps to protect the client against a portfolio
managers unethical behavior.
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Dr. Tekeste B, Department of

Accounting and Finance

Contd
2. Study current financial and economic
conditions and forecast future trends.
- The investors needs, as reflected in the policy
statement, and financial market expectations
will jointly determine investment strategy.

3.

Construct the portfolio

allocate available funds to
meet goals and minimize
investors risks
Focus: meet Dr.the
investors needs at
Tekeste B, Department of

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Accounting and Finance

Contd
4. Monitor and update
oRevise policy statement as
needed
oModify investment strategy
accordingly
oRebalance portfolio
oEvaluate portfolio performance
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Dr. Tekeste B, Department of

Accounting and Finance

Summary on Asset
allocation
When built correctly, a multi-asset
portfolio achieves equity-like returns with
bond-like risks
Asset allocation (diversification): Dont
put all your eggs in one basket
Asset allocation requires:
o Depth
o Breadth
o Portfolio (blended assets) has synergy
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Dr. Tekeste B, Department of

Accounting and Finance

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Portfolio has synergy

(Efficient frontier)

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Comparison: between
individual asset and multiasset portfolio

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Annual returns for multiAsset portfolio

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Multi-asset vs single asset

For how
many years
does a single
asset bit the
aggregate
portfolio?
Avoid
large
losses
Reduce
the
frequency
of losses

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Accounting and Finance

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Asset allocation

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Dr. Tekeste B, Department of

Accounting and Finance

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