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CHAPTER2
THEASSETALLOCATIONDECISION
AnswerstoQuestions
1.Inansweringthisquestion,oneassumesthattheyoungpersonhasasteadyjob,adequate
insurancecoverage,andsufficientcashreserves.Theyoungindividualisinthe
accumulationphaseoftheinvestmentlifecycle.Duringthisphase,anindividualshould
considermoderatelyhigh-riskinvestments,suchascommonstocks,becausehe/shehasa
longinvestmenthorizonandearningsability.
2.Inansweringthisquestion,oneassumesthatthe63-year-oldindividualhasadequate
insurancecoverageandacashreserve.Dependingonherincomefromsocialsecurity,
shemayneedsomecurrentincomefromherretirementportfoliotomeetlivingexpenses.
Atthesametime,shewillneedtoprotectherselfagainstinflation.Removingallher
moneyfromhercompany'sretirementplanandinvestingitinmoneymarketfunds
wouldsatisfytheinvestor'sshort-termcurrentincomeneeds.Investinginlong-term
investments,suchascommonstockmutualfunds,wouldprovidetheinvestorwith
neededinflationprotection.
3.Typicallyinvestmentstrategieschangeduringanindividuafslifetime.Inthe
accumulatingphase,theindividualisaccumulatingnetworthtosatisfyshort-termneeds
(e.g.,houseandcarpurchases)andlong-termgoals(e.g.,retirementandchildren's
collegeneeds).Inthisphase,theindividualiswillingtoinvestinmoderatelyhigh-risk
investmentsinordertoachieveabove-averageratesofreturn.
Intheconsolidatingphase,aninvestorhaspaidoffmanyoutstandingdebtsandtypically
hasearningsthatexceedexpenses.Inthisphase,theinvestorisbecomingmore
concernedwithlong-termneedsofretirementorestateplanning.Althoughtheinvestoris
willingtoacceptmoderateportfoliorisk,he/sheisnotwillingtojeopardizethe“nest
egg."
Inthespendingphase,thetypicalinvestorisretiredorsemi-retired.Thisinvestorwishes
toprotectthenominalvalueofhis/hersavings,butatthesametimemustmakesome
investmentsforinflationprotection.
Thegiftingphaseisoftenconcurrentwiththespendingphase.Theindividualbelieves
thattheportfoliowillprovidesufficientincometomeetexpenses,plusareservefor
uncertainties.Ifaninvestorbelievesthereareexcessamountsavailableintheportfolio,
he/shemaydecidetomake“gifts“tofamilyorfriends,institutecharitabletrusts,or
establishtruststominimizeestatetaxes.
4.Apolicystatementisimportantforboththeinvestorandtheinvestmentadvisor.Apolicy
statementassiststheinvestorinestablishingrealisticinvestmentgoals,aswellas
providingabenchmarkbywhichaportfoliomanager'sperformancemaybemeasured.
5.StudentExercise
6.The45-yearolduncleand35-yearoldsisterdifferintermsoftimehorizon.However,
eachhassometimebeforeretirement(20versus30years).Eachshouldhavea
substantialproportionofhis/herportfolioinvestedinequities,withthe35-yearoldsister
possiblyhavingmoreequityinvestmentsinsmallfirmsorinternationalfirms(i.e.,can
tolerategreaterportfoliorisk).Theseinvestorscouldalsodifferincurrentliquidityneeds
(suchaschildren,educationexpenses,etc.),taxconcerns,and/orotheruniqueneedsor
preferences.
7.Beforeconstructinganinvestmentpolicystatement,thefinancialplannerneedstoclarify
theclienfsinvestmentobjectives(e.g.capitalpreservation,capitalappreciation,current
incomeortotalreturn)andconstraints(e.g.liquidityneeds,timehorizon,taxfactors,
legalandregulatoryconstraints,anduniqueneedsandpreferences).
8.StudentExercise
9.CFAExamination111(1993)
9(a).Atthispointweknow(orcanreasonablyinfer)thatMr.Franklinis:
?unmarried(arecentwidower)
?childless
?70yearsofage
?ingoodhealth
?possessedofalargeamountof(relatively)liquidwealthintendingtoleavehisestate
toatax-exemptmedicalresearchfoundation,towhomheisalsogivingalarge
currentcashgift
?freeofdebt(notexplicitlystated,butneitheristheopposite)
?inthehighesttaxbrackets(notexplicitlystated,butapparent)
?notskilledinthemanagementofalargeinvestmentportfolio,butalsonotacomplete
novicesinceheownedsignificantassetsofhisownpriortohiswife'sdeath
?notburdenedbylargeorspecificneedsforcurrentincome
?notinneedoflargeorspecificamountsofcurrentliquidity
Takingthisknowledgeintoaccount,hisInvestmentPolicyStatementwillreflectthese
specifics:
Objectives:
ReturnRequirements:Theincidentalthrow-offofincomefromMr.Franklin'slargeasset
poolshouldprovideamorethansufficientflowofnetspendableincome.Ifnot,sucha
needcaneasilybemetbyminorportfolioadjustments.Thus,aninflation-adjusted
enhancementofthecapitalbaseforthebenefitofthefoundationwillbetheprimary
returngoal(i.e.,realgrowthofcapital).Taxminimizationwillbeacontinuingcollateral
goal.
RiskTolerance:Accountcircumstancesandthelong-termreturngoalsuggestthatthe
portfoliocantakesomewhataboveaveragerisk.Mr.Franklinisacquaintedwiththe
natureofinvestmentriskfromhispriorownershipofstocksandbonds,hehasastilllong
actuariallifeexpectancyandisingoodcurrenthealth,andhisheir-thefoundation,
thankstohisgenerosity-isalreadypossessedofalargeassetbase.
Constraints:
TimeHorizon:EvendisregardingMr.Franklin'sstill-longactuariallifeexpectancy,the
horizonislong-termbecausetheremainderofhisestate,thefoundation,hasavirtually
perpetuallifespan.
LiquidityRequirement:Givenwhatweknowandtheexpectationofanongoingincome
streamofconsiderablesize,noliquidityneedsthatwouldrequirespecificfundingappear
toexist.
Taxes:Mr.Franklinisnodoubtinthehighesttaxbrackets,andinvestmentactionsshould
takethatfactintoaccountonacontinuingbasis.Appropriatetax-shelteredinvestment
(standingontheirownmeritsasinvestments)shouldbeconsidered.Taxminimization
willbeaspecificinvestmentgoal.
LegalandRegulatory:Investments,ifunderthesupervisionofaninvestment
managementfirm(i.e.,notmanagedbyMr.Franklinhimself)willbegovernedbystate
lawandthePrudentPersonrule.
UniqueCircumstances:Thelargeassettotal,thefoundationastheirultimaterecipient,
andthegreatfreedomofactionenjoyedinthissituation(i.e.,freedomfromconfining
considerations)areimportantinthissituation,ifnotnecessarilyunique.
9(b).Giventhatstockshaveprovided(andareexpectedtocontinuetoprovide)higherrisk-
adjustedreturnsthaneitherbondsorcash,andconsideringthatthereturngoalisfbrlong-
term,inflation-protectedgrowthofthecapitalbase,stockswillbeallottedthemajority
positionintheportfolio.ThisisalsoconsistentwithMr.Franklin'sabsenceofeither
specificcurrentincomeneeds(theongoingcashflowshouldprovideanadequatelevel
forcurrentspending)orspecificliquidityneeds.Itislikelythatincomewillaccumulate
tosomeextentand,ifso,willautomaticallybuildaliquidemergencyfundfbrMr.
Franklinastimepasses.
Sincetheinheritedwarehouseandthepersonalresidencearesignificant(15%)realestate
assetsalreadyownedbyMr.Franklin,nofurtherallocationtothisassetclassismade.It
shouldbenotedthatthewarehouseisasourceofcashflow,adiversifyingassetand,
probably,amodestinflationhedge.Fortaxreasons,Mr.Franklinmaywishtoconsider
puttingsomedebtonthisasset,freeingadditionalcashforalternativeinvestmentuse.
Giventhelong-termorientationandtheabove-averagerisktoleranceinthissituation,
about70%oftotalassetscanbeallocatedtoequities(includingrealestate)andabout
30%tofixedincomeassets.Internationalsecuritieswillbeincludedinbothareas,
primarilyfortheirdiversificationbenefits.Municipalbondswillbeincludedinthefixed
incomeareatominimizeincometaxes.Thereisnoneedtopressforyieldinthissituation,
noranyneedtodeliberatelydowngradethequalityoftheissuesutilized.Venturecapital
investmentcanbeconsidered,butanycommitmenttothis(orother“alternative“assets)
shouldbekeptsmall.
Thefollowingisoneexampleofanappropriateallocationthatisconsistentwiththe
InvestmentPolicyStatementandconsistentwiththehistoricalandexpectedreturnand
othercharacteristicsofthevariousavailableassetclasses:
Current
Range(%)Target(%)
Cash/MoneyMarket0-50
U.S.FixedIncome10-2015
Non-U.S.FixedIncome5-1510
U.S.Stocks(LargeCap)30-453()
(SmallCap)15-2515
Non-U.S.Stocks15-2515
RealEstate10-1515*
Other0-50
100
*IncludestheFranklinresidenceandwarehouse,whichtogethercomprisethe
proportionoftotalassetsshown.
AnalternateallocationcouldwellbeweightedmoreheavilytoU.S.fixedincome
andlesssotoU.S.stocks,giventhenearequalityofexpectedreturnsfromthose
assetsasindicatedinTable4.
CHAPTER2
AnswerstoProblems
1.Mostexpertsrecommendthatabout6month'sworthoflivingexpensesbeheldincash
reserves.Althoughthesefundsareidentifiedas"cash,“itisrecommendedthattheybe
investedininstrumentsthatcaneasilybeconvertedtocashwithlittlechanceoflossinvalue
(e.g.,moneymarketmutualfunds,etc.).
Mostexpertsrecommendthatanindividualshouldcarrylifeinsuranceequalto7-10times
anindividual'sannualsalary.Anunmarriedindividualshouldhavecoverageequaltoat
least7timessalary,whereasamarriedindividualwithtwochildrenshouldhavemore
coverage(possibly9-10timessalary).
2.Married,filingjointly,$20,000taxableincome:
Marginaltaxrate=15%
Taxesdue=$20,000X.15=$3,000
Averagetaxrate=3,000/20,000=15%
Married,filingjointly,$40,000taxableincome:
Marginaltaxrate=15%
Taxesdue=$40,000x.15=$6,000
Averagetaxrate=6,000/40,000=15%
Married,filingjointly,$60,000taxableincome:
Marginaltaxrate=28%
Taxesdue=$6,780+.28($60,000-$45,200)
=$6,780+$4,144=$10,924
Averagetaxrate=10,924/60,000=18.21%
3.Singlewith$20,00()taxableincome:
Marginaltaxrate=15%
Taxesdue=$20,000X.15=$3,00()
Averagetaxrate=3,000/20,000=15%
Singlewith$40,000taxableincome:
Marginaltaxrate=28%
Taxesdue=$4,057.50+.28($40,000-$27,050)
=$4,057.50+$3,626=$7,683.50
Averagetaxrate=7,683.50/40,000=19.21%
Singlewith$60,000taxableincome:
Marginaltaxrate=28%
Taxesdue=$4,057.50+.28($60,000-$27,050)
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